Monetary policy in wait-and-watch mode

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Updated: February 3, 2016 7:30:52 AM

WIth an enhanced LCR and lagging deposit growth, RBI has to proactively manage the liquidity deficit in the system

rbiThe Indian economy is experiencing some gain in momentum—RBI’s outlook reveals a pick-up in the near-term. (PTI)

The RBI policy announcement maintaining a status quo was on expected lines. The decision was guided by uncertainty in global markets. Additionally, with the Union Budget round the corner, RBI may have preferred to adopt a wait-and-watch policy. However, the central bank has also mentioned that the inflation trajectory is evolving as per expectations; hence, there may be reasons to believe that RBI will continue in an accommodative mode.

Meanwhile, fragility in the global economic developments persist. Though the US labour market continues to support domestic demand—albeit, with stolid manufacturing—and deflation risks are possibly receding in the euro area, Japan is still mired in trouble despite the unique measures taken by its authorities. The Indian economy is experiencing some gain in momentum—RBI’s outlook reveals a pick-up in the near-term. The dynamics of the service sector indicates continued acceleration in road construction and railway freight. On the external front, though exports remained muted, India continues to be a favourable destination for FDI.

There is one point of concern, though. Since the last monetary policy, system liquidity has been in a significant deficit mode. As of now, the liquidity deficit averages around R1.5 trillion, compared to around R500 billion deficit over October-November. There are reasons to believe that this may have been also driven by factors other than seasonal ones, like depletion in net foreign exchange assets. RBI, however, has actively intervened through variable term repos to mitigate such liquidity tightness. With an enhanced Liquidity Coverage Ratio (LCR)—(from 60% to 70%—kicking in from January 2016 and deposit growth lagging, RBI may have to be proactive in managing the liquidity deficit through tools available at its disposal. Additionally, in a situation of capacity underutilisation, like the one we are currently witnessing, any possible liquidity injection may not be counterproductive as far as fuelling inflation is concerned.

Another cause of liquidity tightness is the sudden jump in currency demand by the public. For example, in the current fiscal, currency with the public has increased by a sharp 27%. Such an increase defies logic as nominal growth is currently weak. There may be two possible divergent explanations for this. First, this may be explained by continued currency demand from the public even after the festive season. If this is so, this augurs well for buoyancy in consumer demand going forward. The alternative explanation could be that when people expect declining prices, they become less inclined to spend, and also less inclined to borrow. In the words of Paul Krugman “After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield!” Whatever be the reason, this trend needs to be watched very closely.

The announcement of the central bank regarding making it easier to do business and facilitating growth of start-ups, consonant with the government’s Startup India initiative, is a welcome one. These measures will create an enabling environment for receiving foreign venture capital, differing contractual structures embedded in investment instruments, deferring receipt of considerations for transfer of ownership, facilities for escrow arrangements and simplification of documentation and reporting procedures.

The enhanced LCR norms will also necessitate new products on the part of the banks. For example, banks in India provide working capital finance to their customers by means of cash credit (CC) limits. Cash credit is provided as a running account, which basically acts as a way to transfer working capital, cycle planning and forecasting function of customers to the banks. Large cash credit limits, that can be drawn by the borrowers without any notice, may pose liquidity challenges for the banks. In addition, undrawn limits are considered as part of the possible outflows for LCR, resulting in banks being forced to maintain high-quality liquid assets (HQLA) that only means additional 4.5% G-sec holdings. Steps may be thus taken by the banks to eventually replace CC with working capital demand loans (WCDL). Interestingly, drawls by customers under WCDL facility for specified durations would lead to development of term money market in India. New alternatives like invoice discounting and secured fixed rate note, on the lines of asset-backed commercial paper, prevalent in developed markets may also be introduced to replace the prevalent CC system over due course.

On the deposit side, banks should be ready to offer non-callable deposits as a product at least to those customers for whom the run-off factor is higher. This will ensure lower bank holdings in HQLA, and hence a larger pie of fund for lending for productive purposes.

In short, banks in India are on the cusp of a transformational change against the background of greater autonomy being envisaged for public sector banks.

The author is chairman, State Bank of India. Views are personal

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