A rate cut will not achieve anything

In September 2016, with an amendment to the Reserve Bank of India (RBI) Act 1934, almost eight decades of operations relating to monetary policy goals, frameworks, and processes were given a goodbye. History was created with the metamorphic transformation, essentially from an individual (read governor of the RBI) to a committee-based approach with the formation of the Monetary Policy Committee. In a true sense, this courageous and contemporaneous joint decision by the Government and RBI will be recorded as a milestone when the definitive history of the RBI is written.

MPC with six members (three ex officio members from the RBI, including the governor, and three outside members appointed for a term of four years) started functioning in October 2016 with the monetary policy goal of maintaining price stability while keeping in mind the objective of growth with a flexible inflation targeting framework. The goal was kept clear if not simple: 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.

One year has gone by. The MPC has met six times so far and deliberated on the policy interest rate required to achieve the inflation target. It reached a consensus decision to reduce the policy repo rate only once (October 4, 2016) from 6.50 per cent to 6.25 per cent. The committee believed then that the inflation outcome would be favourable during the rest of the year. The inflation and growth situation turned adverse due to demonetisation and the MPC took a unanimous decision to hold the policy rate at 6.25 per cent in three meetings of December, 2016, February 2017 and April 2017. The policy repo rate was lowered in August 2017 to 6 per cent but this time in a split vote, marking a period when dissent came to the fore and members placed on record big differences, including questions being raised on the RBI’s inflation projections.

From the foregoing, we may conclude that the monetary policy process through a committee proved the point that any decision taken unilaterally is sub-optimal. Gradually, MPC deliberations and decisions are becoming transparent with high integrity. However, these decisions need also to be more credible and predictable. This critically hinges on inflation-growth management by the authorities. It is a misconception that the RBI is for inflation management and the Government is for growth management. Both are duty-bound to deliver non-inflationary growth.

At the same time, it should be clear that the MPC has no role on the issue of delivery of bank credit and can only influence the cost of bank credit through its decision on the policy repo rate. However, this repo signal must travel to the bank lending rate along a transmission system that has been jammed for some time now. MPC may move. But the banks don’t. So what’s next?

The RBI has been advocating of late a so-called market-related benchmark like the treasury bill rate or Certificate of Deposit (CD) rate as new reference points to relate to the bank lending rate. However, this misses the point that the existing and well tried out practices of base rate, marginal cost lending rate, and even the older prime lending rate (though decided by banks) had market elements built within it. In other words, these rates never were independent of market rates.

In a sense, this is the RBI trying to patchwork a solution when the problem lies elsewhere. The critical issue is not the cost of credit (interest rate) but a take-off for investment lending for productive use to drive growth. This requires the RBI and the Government to jointly advice and even pressure the banks to separate out NPAs into two buckets immediately — those with structural issues and cases of wilful default versus NPAs caused by a genuine downturn in the business cycle. The bankruptcy and insolvency processes set up are unlikely to resolve the big mess that is now of the order of 10 per cent of India’s GDP.

This is a burning issue and MPC has no role in it. But this is the issue that has jammed the transmission mechanism and to that extent it handicaps the MPC’s functioning. The MPC cannot lay a predictable, credible, sustainable path to growth in the absence of transmission.

Hence, no time should be lost in beginning the process of hunting down and awarding exemplary punishment to the defaulters and their banker friends because they have played with public money. Unless the Government and the RBI take the lead in this, nothing else will work. In the absence of this, the MPC can have finely nuanced debates but they will be false debates, distractors because they draw attention away from the elephant in the room. This is what we saw when there were words and time spent on terms like “inflation forecast”, “output gap” and “capacity utilisation”, which are factual measures and instead became the focus of the nitty-gritty of how they are read.

The MPC will meet for the first time in its second year of establishment on December 6. Its decisions for the rest of the current fiscal year in December and February 2018 hinge on the inflation outlook, demand for credit offtake, delivery of bank credit, cost of bank credit and the overall credible monetary policy transmission.

In some sense, Governor Urjit Patel has given a forward guidance with his classic statement: “We should aim at achieving the inflation target without losing sight of supporting economic growth.”

Going by the market sentiment and political mood, a policy repo rate cut in December 2017 and February 2018 will be a welcome move. But the moot question is what purpose this will achieve. Evidence suggests that the growth rate currently is predominately consumption-led and household debt is looming large. Any rate reduction could fuel private consumption and household debt even more. Investment-led growth depends more on healthy balance sheets of private corporates, which can fuel an appetite for credit. Right now, no one is particularly hungry except consumers, who are often blind to bigger headwinds.

Therefore, any rate cut at this juncture becomes a burden rather than a benefit. It is now time MPC moves to a medium-term projection for policy repo rate from a crisis management approach for revival of growth. Now the policy repo rate is 6 per cent. Taking into account an average 4 per cent inflation and 7.5 to 8 per cent growth, what could be the sustainable policy repo rate? Since fiscal policy is rule-based, it is appropriate that the MPC should come out with a rule-based policy repo rate and a medium-term path to achieve it.

Pattnaik is a former central banker. Rattanani is a senior journalist.

Both are faculty members at SPJIMR. The views are personal. Via The Billion Press

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