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As widely expected, on the completion of the first MPC meeting for the current fiscal, the policy repo rate was kept unchanged at 4%. The accommodative stance was also kept unchanged. However, the focus henceforth will be on withdrawal of accommodation.
The consensus in the market seems to be that the actual rise in the repo rate is at least one more monetary policy meeting away. Overall, a major aim of this policy was to prepare the financial markets for tightening later this year and also for a new liquidity management regime.
New LAF Design
Narrowing of the width of the LAF corridor from the current 90 basis points to its pre-pandemic level of 50 basis points could be seen as the first concrete step for both policy and liquidity normalisation. However, this has been brought about through a significant change in the design of LAF itself. The policy repo and reverse repo rates, both of which are collateralised overnight rates, are the upper and lower bounds respectively of the corridor now. These will be replaced by two standing facility rates, viz. MSF (4.25%) and SDF (3.75%).
A major aim of this policy was to prepare the financial markets for tightening later this year and also for a new liquidity management regime
One implication of this tweaking is that the policy repo rate (4%) is exactly at the middle of the corridor. However, whether this symmetric configuration will be maintained with changes in the repo rate in future is not clear yet. Nevertheless, it will be apposite to highlight a few aspects concerning the new design: (i) It is possible that the SDF will eventually become the main tool for absorption of excess liquidity in the banking system. From the RBI’s point of view, SDF has an advantage over reverse repo. Since no collateral is required to be parted with by the RBI for absorbing liquidity, the mechanism does not constrain it as regards the total amount that can be soaked.
A few years ago, the RBI’s holding of G-Secs that can be offered as collateral for reverse repo was much less than the amount of liquidity that needed to be absorbed; (ii) Having a non-collateralised (clean) SDF rate for the floor and a collateralised rate (MSF) for the ceiling of the corridor makes the design look somewhat incongruent, conceptually; (iii) Although it seems obvious that the RBI wants to erase the ‘stigma’ that was previously associated with borrowing by any bank under the MSF, it is not clear if the RBI wants the MSF mechanism to be the mainstay for a short-term liquidity injection. Till this happens, there is likely to be some uncertainty as to how the call rate will move inside the redesigned corridor; and (iv) It’s well-known that at times of excess liquidity such as now, there are good opportunities of arbitrage between the market repo rate and the reverse repo rate, which are routinely taken advantage of by some banks.
Despite there being clear signs of accentuating global tension and rising inflation in few major economies, the MPC took a sanguine position that inflation would moderate nicely in 2022-23 and, hence, the focus of the monetary policy in the foreseeable future should continue to be on supporting growth.
Quite a few of them would have high excess SLR in their possession, which are used for borrowing through market repo/TREPS at lower rates, and the amounts so borrowed are placed under reverse repo at higher rates. For example, on Friday (April 8), the market repo rate was around 3.40% and, with SDF 3.75%, a clear arbitrate opportunity of 30 basis points would be possible for banks with excess SLR. Since any arbitrage opportunity can only be reduced by more arbitrage and not less of it, there is nothing wrong, per se, in banks gaining from the arbitrage in question. But this creates an incentive for banks to opt for excess SLR, which do not attract capital charge, for engaging in arbitrage in preference to making loans which attract capital charge.
Growth - Inflation situation in a flux
The risk of lower growth and higher inflation for 2022-23 vis-à-vis the projections made two months ago in the last MPC meeting in February now stands realised. Projected growth rate has been trimmed from 7.8% to 7.2%, while the projected CPI inflation has been revised significantly upwards from 4.5% to 5.7%. Both the new projections, especially the one on inflation are likely to undergo changes in the days to come, as the underlying factors are changing fast. That said, two observations would be relevant here. One, despite there being clear signs of accentuating global tension and rising inflation in few major economies at the time of its last meeting, the MPC took a sanguine position that inflation would moderate nicely in 2022-23 and, hence, the focus of the monetary policy in the foreseeable future should continue to be on supporting growth.
India like most other emerging market countries will face even larger capital outflows, which, given the rupee’s moderate overvaluation in real terms, may cause it to come under fresh pressure, with negative implications for the rupee price of imported crude.
The facts and ratiocinations put forth by a few members of the MPC in support of a well-behaved future inflation trajectory, as revealed in the minutes of the last meeting, make interesting reading indeed. However, by all indications, the MPC has now forsaken that position and has accorded primacy to inflation control, which it should always do. Two, revised inflation projection for 2022-23 at 5.7% assumes, among others, average crude oil (Indian basket) price at US$ 100/barrel. The elephant in the room here is the US$/INR exchange rate. In the event of a deepening/widening of the on-going conflict in the Black Sea region, India like most other emerging market countries will face even larger capital outflows, which, given the rupee’s moderate overvaluation in real terms, may cause it to come under fresh pressure, with negative implications for the rupee price of imported crude.
Needless to say, the market is not sure whether the RBI is now ‘ahead of the curve’
Close on the heels of the policy announcement, the 10-year G-Sec yield moved up by 10-12 basis points, highlighting the market’s response to a higher inflation projection. Needless to say, the market is not sure whether the RBI is now ‘ahead of the curve’. If the next inflation print turns out to be 6% or higher, then the yield curve will steepen further and the RBI’s current plan of a calibrated and phased policy normalisation over an extended period will receive a sure jolt.
Regulatory measures
An important measure pertains to the raising of the limit for holding SLR securities by banks in the Held-to-Maturity (HTM) category, which has no mark-to-market requirement. Right now, the limit is 22% (of NDTL) for securities acquired between September 1, 2020 and March 31, 2022. This limit has been enhanced to 23% for securities acquired between April 1, 2022 and March 31, 2023. Clearly, this is to help the Central government’s very large borrowing programme for the current fiscal. Sadly, this will not be cost-free for banks. As interest rates are likely to rise in the rest of this fiscal and thereafter, pushing up the funding cost for banks, their net interest income on the HTM portfolio will decline. Further, the stated plan to bring down the limit from 23% to 19.5% in the first quarter of 2023-24 itself appears overly ambitious.
(The writer is a former central banker and a consultant to the IMF)
The image seen on the home page is an image grab from the cover of the Monetary Policy Report of April 2022