Rules, not discretion, must guide monetary policy

Quite predictably, a good part of the media and a good number of commentators have applied ornithological metaphors to describe the 25-basis points cut in the policy rate by the RBI in its fourth bi-monthly monetary policy review for this fiscal held on October 4, 2016. So it might appear that the hawks have flown and the doves have arrived with the policy repo rate now at 6.25 per cent – a six year low. The RBI expects that the transmission of this cut in lowering the costs of new borrowing in the economy will be more effective than the earlier cuts.

In one respect, the fourth bi-monthly policy review exercise this year is historic: it involved the maiden decision-making by RBI's first Monetary Policy Committee(MPC), in pursuance of a primary mandate to keep the  consumer inflation between two per cent and six per cent. That the adoption of a legally backed inflation-targeting discipline and the constitution of the MPC will enhance both the process and quality of monetary policy-making is widely acknowledged. However, it is equally important for the MPC to establish its institutional credibility by demonstrating that its decision-making framework is logical, consistent, transparent and effective.  Gauged by those standards, the first rate decision of the MPC does not inspire much confidence, though.

None of the documents compiled and published by the RBI in connection with this policy review, including the one on post-policy conference call with the media, clearly explain the rationale and necessity of the rate cut.  In fact, it is difficult to reconcile some of the key points and facts contained in those documents with the decision. The following table shows the baseline projections of RBI for CPI inflation and GDP growth as of the fourth quarter of 2016-17 and 2017-18 that were made in the last two Monetary Policy Reports(MPR) - of April 2016 and September 2016:

Clearly, there has been an uptick in projected future inflation during the last six months, while the growth outlook continues to be robust. The latest round of surveys conducted by the RBI corroborates these projections. The household survey put the expected inflation in three months and 12 months at 9.5 per cent and 11.4 per cent respectively. During the period between September 2006 and June 2008, when the current inflation expectation was low, the future inflation expectations were also low. In the recent past, however, despite a reduction in inflation, both the current and the future inflation expectations are trending higher.

One is hard put to figure out how under the present inflation-targeting paradigm, a rate cut can be justified when the projected inflation over the next six months is close to the upper limit of 6 per cent and the projected GDP growth is close to 8 per cent which is considered to the highest sustainable rate over the medium term. The fact that the decision was unanimous will raise doubts whether all the relevant issues were debated and discussed by the MPC. One wonders if the MPC felt any need to distance itself from the legacy of the former Governor Dr. Raghuram Rajan.

It is likely that the MPC will go through an initial phase of 'learning by doing' as it evolves and matures as a professional policy-setter. But it is essential that it adopts a rule-based approach and methodology from the start itself and eschews too much discretion in order to find space for rate cuts, ostensibly for supporting growth.  

As regards the impact of the rate cut, three issues loom large: credit growth, stressed assets/NPA of banks and corporate investment. Extremely sluggish credit growth on the part of PSU banks to sectors other than retail borrowers is going to last for quite some time. And so long as the credit cost by way of provisioning for NPA remains high, as is the case now, the likelihood of a reduction in borrowing cost in response to cuts in the policy rate will continue to be low.    

Transmission of the monetary policy will continue to remain sub-optimal till the estimated Rs. 13.3 trillion of stressed assets/NPA of banks are resolved. While the RBI has done a good job in pushing banks to recognise their NPAs, it has been quiet on the lack of progress in the resolution of stressed assets/NPA. While the government expects a good number of NPA to become regular over the next few years, thereby making possible reversal of provisions made against them, there is little evidence of any progress on the ground in this regard.  

The various schemes for debt resolution such as CDR, SDR and the most recent S4A have not had any noticeable impact so far. Illustratively, between 2009-10 and 2014-15, the total number of cases referred to CDR was 253 with an aggregate exposure of Rs. 2.77 trillion, out of which only five cases involving Rs. 16 billion have so far exited CDR successfully.  SDR has been a non-starter and S4A has yet to take off. 

The RBI and the government must empower the boards of PSU banks to take decisions on one-time settlement and debt write-off on commercial considerations alone, based on well-defined policies and procedures to be formulated by the latter for this purpose.

The fundamental flaw in the current debt resolution schemes is the lack of an enabling mechanism for infusion of fresh equity in the debtor companies. In most cases, fresh equity is unlikely without a repricing of the companies’ assets and liabilities that would lead to a proper price discovery of its equity. This will entail, among other things, an appropriate reduction in the companies’ debt owed to banks.   It is clear that debt resolution by banks cannot happen with RBI issuing directives in a ‘command and control’ fashion.

The RBI and the government must empower the boards of PSU banks to take decisions on one-time settlement and debt write-off on commercial considerations alone, based on well-defined policies and procedures to be formulated by the latter for this purpose.  Finally, the PSU banks should be enabled by the government to devise a solution to the following asymmetric incentives faced by their staff in relation to stressed assets/NPA: the downside of loans becoming NPAs and unrecoverable is much less compared to the downside of a vigilance probe in respect of genuine debt resolutions.

In sum, the decision of the newly formed MPC to cut the repo rate at this time is likely to hurt its credibility. Further, it will do precious little with regard to the problems associated with very high stressed assets/NPAs of banks, the resolution of which alone can spur credit growth and corporate investment that will lead to job creation for the youth of India.   

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