By Ashvin Parekh
The monetary policy of April suggested the Reserve Bank of India’s (RBI) recent shift to an accommodative stance, repo rate cuts, and liquidity infusion measures, reflecting elements of unconventional policy in response to the global headwinds. Unconventional monetary policy (UMP) refers to central bank actions and go beyond standard tools like changing interest rates. The key unconventional tools include forward guidance, asset purchase, term funding facilities, operation twist, targeted long-term repo operations (TLTROs), and adjustments to market operations. In this article, we discuss the measures adopted by the RBI since the pandemic in rate transmission, liquidity infusion, currency stabilisation, and, in the recent past, its stance on economic growth support in the backdrop of tamed inflation. The benefits of the unconventional policy for the economy and some possible unintended consequences are also discussed.
It may be observed that the UMPs in Japan and the US differ from the RBI’s approach, and each involves the central bank’s balance sheet expansion. Japan’s policy has focused on liability-side expansion, and the US one on asset-side approach.
The RBI has indeed used several unconventional tools in the past few policies. These include the operational twist where it has conducted special open market operations (OMOs) to manage long-term yields and improve monitoring transmission; long-term repo operations (LTROs) and TLTROs (where it has injected durable liquidity into the banking system); and supporting credit flow, liquidity infusion with the RBI injecting large amounts through bond purchases, forex swaps, and variable rate repo auctions, and — last but not the least — forward guidance where it has used communication to shape market expectations.
The RBI’s current approach and intent is largely communicated in its recent actions as of April, which included a repo rate cut and shift to an accommodative stance with continued flows on liquidity infusion and supporting economic growth as inflation moderates. The intended approach is to ensure smooth monetary transmission, keep borrowing cost low, and support recovery amid global uncertainties and domestic growth concerns. The policy signals readiness to use both conventional and unconventional tools as needed, aiming for financial stability, adequate liquidity, and effective policy transmission. In recent years, therefore, the RBI has actively used unconventional policy measures particularly to address slow monetary transmission and support economic growth. It’s stated objective is flexible, pragmatic, and focused on maintaining growth and stability.
Now let us examine the benefits of its approach and some unintended consequences. The major benefit is lower borrowing costs, which is due to the injection of liquidity and managing yields. This has helped reduce cost of funds for businesses and the government for large investment plans. The second major outcome has been an improved credit flow in the economy. Tools like LTROs and TLTROs have ensured continued credit flow to stressed sectors, preventing a credit crunch particularly during a crisis like the pandemic. The third aspect is enhanced monetary transmission.
These measures have helped align market rates more closely with policy rates, making the monetary policy more effective. It is observed that the banking industry and lending companies take longer to transmit the policy rates. There is a need to have measures in place to monitor the transmission. Then there is the aspect of financial market stability. The liquidity support and asset purchase have stabilised financial markets during periods of stress, reducing volatility and supporting confidence. The recent narratives from the RBI after the April policy announcements do suggest large asset purchasing measures the central bank may undertake to meet the stated objectives. The most interesting outcome of the UMP would be to boost aggregate demand by making credit cheaper and more accessible. The unconventional policy measures can stimulate consumption and investment, aiding economic recovery.
Let us now examine the unintended consequences of the UMPs. The first and foremost is riskier lending. Increased liquidity and lower rates may encourage banks to lend to high-risk borrowers, potentially raising future default rates and impacting bank profitability. The second consequence could be asset price inflation; large-scale liquidity injection can inflate prices of assets like real estate and stocks, increasing the risk of bubbles. The other consequence of the UMPs could be distorted credit allocation. Banks may reallocate loans away from safer investment-grade to risky sectors, which would undermine the overall quality of credit. Reduced incentive for financial discipline could be another unintended consequence of UMP, and of course the most critical one would be challenges in policy exit. Withdrawing unconventional support can be difficult without causing market disruptions of higher interest rates or tight liquidity conditions, leading to financial vulnerabilities.
In the backdrop of the RBI’s UMP measures, let us examine how banking companies should respond constructively. The first critical step would be strengthening the monetary policy transmission by aligning deposit and lending rates. Banks should reduce the spread between deposit and lending rates to ensure the RBI’s rate cuts translate into lower borrowing cost for businesses and households. One is reminded of slow transmission of rates earlier when the rates were hiked. The mistake of slow rate transmission, particularly to deposit-holders, have perhaps made deposits unattractive and household savings got channelled to capital markets. Banks are finding it difficult to mobilise deposits and suffering from the lure of higher net interest margins. The second measure that banking companies should take is adopting external benchmark-linked rates (like the repo rate) to improve transparency and responsiveness to the RBI’s policy changes. The third measure would be targeting credit allocation by prioritising productive sectors and avoiding risk concentration. Liquidity management could be strengthened by optimising the RBI’s liquidity tools and reassessing cash reserve ratio and liquidity coverage ratio compliance. Banks must have an enhanced risk assessment framework with dynamic stress-testing and sector-specific risk mitigation. Digital transformation and customer outreach will help the system. In taking these measures, banks will face challenges such as balancing profitability and risk and avoiding liquidity traps.
In conclusion, the UMP steps adopted by the RBI to provide and maintain financial stability in the face of global headwinds support government finances and foster faster economic recovery, as the banking system aligns with the policy measures. This would ensure desired outcomes.
The writer is managing partner, Ashvin Parekh Advisory Services LLP.
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