A welcome move by the RBI

The Reserve Bank of India and the Monetary Policy Committee (MPC) deserve to be congratulated for a fair, balanced and reasonable assessment of the macro economic situation and the decision as a result not to further reduce the policy repo rate, which is the signalling rate for short term interest rates in the economy. The fifth bi-monthly Monetary Policy Statement for fiscal 2017, announced on Wednesday (Dec. 07), has kept the policy repo rate unchanged at 6.25 per cent. This is only the second time that the Monetary Policy Committee is deciding on rates under a new system which has internal and external experts sitting together to decide on the monetary policy. All six members of the Committee voted in favour of keeping rates unchanged, giving us a unanimous assessment provided in the five page statement issued by the RBI. This is a change from the last time around when the Committee at its maiden meeting decided to reduce the policy repo rate by 25 basis points.

On inflation, the impact of demonetisation could be of the order of 10 to 15 basis points in the third quarter of the current fiscal. This on the surface is a marginal impact but the undertone of the announcement today has a note of caution on the upward risks of inflation.

It has now almost become a practice by a range of observers form the banking sector to raise the tempo and put up the demand for lowering of rates every time a policy announcement nears. The arguments stem from a unidirectional perspective that tends to equate a lower policy repo rate with better times for consumers and business, leading to an invigorated business environment. Whatever the merits of that position, which often comes unmindful of concerns on inflation and inflationary expectations, it should be clear that this time is different. The withdrawal of the legal tender status of currency notes of Rs.500 and Rs.1,000 (the so-called Specified Bank Notes, or SBNs) has brought about huge uncertainty in the system, and any attempt to jump in with a decision without due consideration was fraught.

It is here that the Monetary Policy Committee has come forward with what looks like a fairly candid assessment of the situation in the light of withdrawal of SBNs, in particular the impact on inflation, growth and liquidity management.

On inflation, the impact of demonetisation could be of the order of 10 to 15 basis points in the third quarter of the current fiscal. This on the surface is a marginal impact but the undertone of the announcement today has a note of caution on the upward risks of inflation. This is because retail inflation as measured by Consumer Price Index (CPI) excluding food and fuel, the so-called core inflation, has been “resistant to downward impulses”. This means that the economy still faces upward risks of inflation. However, on balance, the Monetary Police Committee kept the inflation projection for Q4 of fiscal 2017 at 5 per cent.

On growth, the withdrawal of SBNs could “transiently interrupt some part of industrial activity in November-December due to delays in payment of wages and purchases of inputs...” In the services sector, “the outlook is mixed with construction, trade, transport, hotels and communications impacted by temporary SBN affects.” In view of this, withdrawal of SBNs will have downside risks in the near term growth and thus the growth projection for 2016-17 has been revised downwards to 7.1 per cent from the initial projection of 7.6 per cent.

This is as clear as a recognition as any that the RBI has explicitly acknowledged the importance of cash intensive sectors such as retail trade, hotels & restaurants, transportation and the unorganised sector –  the very sectors that are now said to reeling and disrupted as a result of demonetisation.

One of the most critical and immediate challenges that the RBI is faced with, however, is liquidity management on account of an unprecedented surge in deposits of SBNs in the banking system. As of today, the RBI has said that as much as Rs.11.55 lakh crore of SBNs have been deposited into the banks. This surge was mopped by the RBI through reverse repo (both overnight and variable in the Liquidity Adjustment Facility, or LAF corridor), incremental Cash Reserve Ration (CRR) and the Market Stabilisation Scheme (MSS) with Cash Management Bill (CMB) with a tenure of 28 days and 35 days. The incremental CRR was a temporary measure which was withdrawn from fortnight beginning Dec.10, 2016. Henceforth, the liquidity released by the discontinuation of the incremental CRR would be absorbed by a “mix of MSS issuances and LAF operations.”

According to available data, there were three MSS operations to mop up liquidity with a total amount aggregating Rs.32,000 crore with an average interest rate above 6 per cent. This has adverse implications for the government budget in terms of higher interest burden. Moreover, as clarified by the RBI Governor Dr. Urjit Patel at the customary news conference today, there will be no impact on the balance sheet of the RBI as a result of the demonetisation. This statement should once and for all put an end to misplaced euphoria that there is a windfall for the government lurking behind the demonetisation.

The RBI assessment today should also serve as an eye opener for the banking system and all those who clamour for a rate cut. Instead for harping on cuts, the banking sector might be well advised to handle the complexities arising in the near term out of liquidity and the concomitant impact on deposits and lending rates, but most of all the challenges that still remain on account of large NPAs in the system.

The banking sector must also recognise that the priority now should be restoring normalcy, meeting the needs of ordinary citizens and particularly the cash sensitive sectors.

In sum, the Monetary Policy Committee is in wait and watch mode, which is the best that can be done in the current circumstances. In this, there is a message for the banking system, which very simply is: Cut rates when you can but needless pressure on the RBI won’t pass muster.

(R K Pattnaik is Professor, SPJIMR. Jagdish Rattanani is Editor, SPJIMR. Views are personal)