The RBI decision to cut the repo rate by 25 basis points was on expected lines. The best thing, however, is the decision to rejig the liquidity management framework from a deficit mode to neutral mode. The conduct of liquidity management for central banks in emerging economies is often more difficult than their counterparts in developed ones for the simple reason that liquidity is influenced by a combination of autonomous and discretionary factors. Among discretionary factors, foreign exchange inflows are extremely volatile and make liquidity forecasting more often a difficult exercise. Interestingly, recently with the unexplained rise in currency in circulation, even the forecasting of a more stable autonomous component (government cash balances strictly not a part of this as it is auctioned) may also have become difficult to predict. To that extent, the RBI decision to also tweak the LAF corridor to 100 basis points is commendable.
RBI has clearly stated the two objectives of liquidity management—one, the need to supply or withdraw short-term liquidity from the market to accommodate seasonal and frictional liquidity; and two, the need to supply durable liquidity in the economy to facilitate growth, while ensuring the monetary policy stance is supported. Going forward, RBI intends to first meet requirements of durable liquidity, and then use its fine-tuning operations to make short-term liquidity conditions consistent with the intended policy stance.
To be fair to RBI, the decision to reverse the liquidity stance from deficit to neutral will ensure injection of liquidity through more OMOs, implying primary liquidity injection and hence deposit creation and credit creation. Currently, since term repo is quickly extinguished, it is not the creation of primary money in the strict sense of the term, even though it has been pushing up reserve money. Also, such OMOs are unlikely to be inflationary, as the industry is currently working with excess capacity.
The decision to narrow the LAF corridor is also a step in the right direction. In fact, empirical studies indicate that, in the euro area, the width of the standing facilities corridor affects banks’ day-to-day liquidity management. It has been shown that the wider the corridor, the greater the interbank turnover, the leaner the central bank’s balance sheet (i.e. the lower the average recourse to standing facilities) and the greater short-term interest rate volatility. To that extent, this move will clearly ensure a better and predictive interest rate regime in terms of lower volatility in interest rates. However, for this to happen, the central bank will have to be extremely careful in ensuring the call rates move in the corridor, as otherwise the credibility of the central bank may be impacted, if the call rates overshot the corridor on a sustained basis. The good thing is that, currently, the market sensitivity to RBI’s “open mouth operations” has been profound, as the central bank has established its reputation as a fearless crusader against inflation. Given this, we believe the market will continue to believe that RBI will ensure day-to-day liquidity on a more sustained basis, no matter how difficult it might be given the fickle nature of discretionary liquidity movements. Interestingly, the assessment of the new liquidity framework shows that, with proactive liquidity management, the effective policy corridor in the second half of the year was +36/-27bps. The weighted average call rate (WACR) spread over the repo rate remained within +/-10bps on 50% of the total number of trading days, and within +/- 20bps on 85% of the total number of trading days.
One important point is that the RBI assessment for the global economy is marred with varied opinions. A fine reading of the lines clearly demonstrates that the health of the global economy is not good. To support this, one draws attention to RBI’s emphasis on jump in gold prices by 16% on safe haven demand. The monetary policy report (MPR), on the other hand, is far more candid and open. Since the MPR of September 2015, the global economy has weakened, with rising downside risks prompting downward revisions to forecasts by several international agencies. Clouding the outlook is the continuing loss of momentum in EMEs, overlaid by the anticipated slowdown in China and tightening financial conditions. This, coupled with weak domestic conditions, makes us believe more repo rates cuts are round the corner.
On the crucial issue of how fast the banks can transmit now, it needs to be noted that any changes in the current MCLR regime comes either through changes in deposit rate or deposit share. In other words, the marginal cost of funds is calculated using actual deposits rate and their respective share in the total deposits. The share of CASA deposits is fairly stable and any reduction in term deposits rate at the current juncture may not be possible, as deposits growth was at a 53-year-low of 9.9% in FY16 (March 18, 2016). So, it will take time for banks to make any reduction in deposits rate further, and hence transmission will happen possibly with a lag.
Before we end, one point of caution though. In FY16, the credit offtake (year-on-year) has shown some signs of improvement and is at 11.3% as on March 18, 2016, compared to the last year’s growth of 9% as on March 20, 2015. The incremental lending has been mostly to the personal loan segment, especially housing, and also Mudra. Additionally, our in-house study about the relation between credit allocated to industry and personal loans over the past 10 years indicates that the industry credit always grander causes personal credit growth and not the other way round. This, in turn, implies that increase in personal loans alone is not enough to suggest an enduring recovery. Furthermore, the historical data reveals that the share of personal loans to total loans by ASCBs increased prior to the global financial crisis of 2008. It increased to 23% by 2006 from 12% in 2001 and then declined subsequently. The current scenario reveals increase in personal loans in total loans, though much below the level reached in March 2009.
In aggregate, this policy could be a game-changer in providing a new direction to monetary policy strategy, rather than stance.
The author is chief economic adviser, SBI. Views are personal