Is RBI following a ‘normalisation’ strategy?

The Monetary Policy Committee of the Reserve Bank of India maintained status quo both in the policy rates as also in the stance on the conclusion of its bi-monthly meeting on December 8.  This outcome was widely anticipated, although a section of the market expected a 15 basis points rise in the reverse repo rate from 3.35% to 3.50%, largely on the back of the first signs of hardening of the overnight rates – both uncollateralised and collateralised – by around 10 basis points since the last policy.  Overall, the policy was more dovish than expected which provided some extra upward push to the equity market which rose by about 1.70% during the day mainly on global clues. One obvious consequence of the ‘no change’ headline is a much higher likelihood of a reverse repo hike in the next meeting of the MPC in February 2022.     

Normalisation strategy – a work-in-progress

From the wordings of the policy statements issued after the last bi-monthly meeting in October as also the dissent on the issue of continuance of the accommodative stance, which continued this time as well, it was apparent that the RBI had set in motion the preparations for policy normalisation under different plausible macroeconomic and pandemic-specific scenarios unfolding in 2022. As could be expected, the strategy for this purpose will be a dynamic one. However, as things stand now, the following seem to be its main elements: In terms of their relative significance, revival of growth for taking the outputs of industrial and service sectors, solidly ahead of their respective pre-pandemic levels would rank much higher than concerns on inflation, if any.

As any hurried policy normalisation could hurt growth possibilities, the RBI’s focus is more on liquidity management

The majority view of the MPC appears to be that any hurried policy normalisation would cause more damage to the growth possibilities of the economy, given the existence of slack and still-weak private investment and private consumption, than attenuating its inflation prospects. Also, the political class of the country wants a ‘feel good’ sense to percolate as wide and as deep as possible, as the country emerges out of one of the most trying periods in its post-independence history. Some have viewed this policy also as an insurance against a major third wave of the pandemic that could be caused by the Omicron mutant. However, given the good progress of vaccination in the country as also the knowledge gathered so far about this virus variant, a repeat of the economic disruption caused by the first or the second wave is unlikely.

The upshot of the foregoing is that the attention and focus of the RBI is more on liquidity normalisation than on any rate action. A major plank of the strategy underlying this approach is to reduce and eventually eliminate the banking system’s dependence on cheap 3-year money made available by way of Targeted Long-Term Repo Operations (TLTRO) through which a total of ₹1,12,900 crore was injected. Banks are now being allowed to pre-pay their entire outstanding amounts under TLTRO, which together constitute about two-thirds of the fund lent by the RBI.

The other important plank is to significantly expand the ambit of term reverse repo auctions at variable rates for absorption of excess liquidity of banks, thereby reducing and eventually eliminating the reliance for this purpose on the overnight operations of the RBI at the policy reverse repo rate. One would expect the (overnight) call money rate to rise, as a consequence, thereby facilitating the upward adjustment of the policy reverse repo rate by the MPC. The idea here could be that the market takes the first step in raising the overnight rate and then the MPC acts and not the other way round. There is nothing novel about this approach; central banks elsewhere have tried it, with mixed success though.                                           

Falling behind the curve?

However, one fallout of this likely strategy would be a heightened risk of the RBI falling behind the curve. For some weeks now, the spread between the 10-year G-Sec yield and the overnight interest rate in India is hovering around a high of 300 basis points. To provide a perspective in this regard, the average of this spread since the end of 2007 till recently is about 110 basis points. As per the standard and accepted norms for interpretation of the yield curve shape in any country, with a fairly active market for government securities like India, the current high steepness indicates a robust pick-up in economic activity together with rising inflation expectations on the part of businesses as also households.

It is not reasonable to expect any major central bank like the RBI to follow a pre-emptive approach to monetary tightening when the economy has just weathered unprecedented demand - as also supply-side disruptions in the wake of the outbreak of the Covid-19 pandemic in March last year. Nonetheless, it cannot afford to fall too much behind the curve as that would leave open the possibility of large doses of interest rate hikes in future, if inflation gets out of control. The chances of that kind of a scenario unfolding do exist: For one thing, core inflation has, of late, crept higher, to 5.9%. For another, both the households and businesses expect inflation to move higher. The WPI inflation reached a 23-year high of 12.54%, as per its last print which came in October. Given the fact that producers now have gained more pricing power than during the pandemic months, it is possible that high wholesale price will get transmitted to retail prices, pushing the CPI beyond 6%. Put differently, the ‘motto of a well-time soft landing’ may well be in a jeopardy if this were to happen.

It cannot afford to fall too much behind the curve as that would leave open the possibility of large doses of interest rate hikes in future

The RBI is worried about the looming prospects of monetary tightening in the major OECD countries, as this would engender some extra challenges for the conduct of monetary policy and balance of payments (BoP) management in India. However, unlike in the autumn of 2013 when the so-called ‘taper tantrums’ emanating from the US caused serious turmoil in the financial markets of many emerging market countries, including India, this time around, the country is now better placed to face it. There exists a very well-defined framework for the conduct of the monetary policy. Institutional arrangements, skills and maturity that are required for this purpose are also available.       

Regulatory measures

The decision to permit banks, which are incorporated in India are also well-capitalised, the freedom to infuse capital in their overseas branches and subsidiaries as also to retain/repatriate/transfer their profits without the RBI’s prior approval, is a welcome step. This type of meaningless exchange controls by another name have served no purpose in the past.  They only confirmed the impression that banks in India are over-regulated but poorly supervised.

Banks in India are over-regulated but poorly supervised

As for the plan to prepare a discussion paper on the prudential norms for classification and valuation of the investment portfolio of banks, one is not sure what is the purpose and objective of this exercise. It is an established and accepted approach globally that the relevant International Financial Reporting Standards are most suitable for the classification and valuation of financial instruments which constitute the investment portfolios of banks.  This being the case, why reinvent the wheel?

(The writer is a former central banker and a consultant to the IMF)