MONETARY POLICY REVIEW. Is this the end of the easing cycle?

As inflation had increased by two percentage points since the last policy — although below the target of four per cent — no one in the market seriously expected the inflation-targeting MPC to recommend any rate cut. On cue, the RBI kept the repos rate at the existing six per cent.

It also increased its inflation forecast slightly to 4.2 to 4.6 per cent from 4 to 4.5 per cent for the second half of the year. But the central bank reduced the growth forecast for 2017-18 from 7.3 per cent to 6.7 per cent on the expectation that growth will pick up in the second half of the year.

The reading of the policy and the exchanges in the RBI press conference do not create expectations of a rate cut in the next policy either, unless the trajectory of growth and inflation change dramatically. In fact, Governor Urjit Patel expressed concerns about fiscal slippages (States, Centre) and its impact on macroeconomic stability.

The sluggishness in investment demand and private capital formation, which is at the root of the slowdown in GDP, cannot be attributed to the transient effect of demonetisation and GST roll out. It is due to the now familiar twin balancesheet that needs to be corrected through deleveraging and resolution in some of the other ways that have opened up.

Hence, interest rate cuts, even if found feasible in the light of inflation coming down, may not help growth unless clogging up of the public sector banks balance sheet is tackled. This is demonstrated by the 25 bps cut in the repos rate in August that did not seem to have any impact on credit or growth.

In the press conference, there were assurances that recapitalisation of PSBs is very much under discussion with the Government and that all options are being explored.

One option tried earlier and can be explored is the recapitalisation bond. As banks do not need liquidity, the Government can inject capital by way of Government bonds. Except to the extent of amount of interest on the bonds, issuing such bonds does not impact fiscal deficit. But they would increase the debt-to-GDP ratio: and this could be transparently disclosed. Although not an ideal solution, this is better than having a banking system being clogged for want of capital.

By making sure that the extra capital through recap bonds is put into those PSBs that have demonstrated a relatively better credit management track record, it may be possible to ensure that moral hazard is minimised. Over time, there is no option but to look at greater privatisation and autonomy of public sector banks.

It is also necessary to look at the role of the exchange rate in economic policy. Some analysts have argued that the high interest rate differential between India and rest of the world has led to carry trades that have resulted in huge capital inflows putting pressure on the rupee to appreciate, eroding competitiveness with consequential impact on growth.

There are limits to how much RBI can intervene and undertake sterilisation operations. The argument put forward is that by reducing interest rates, such inflows will come down and also there could be some treasury gains for banks, as bond yields go down further.

This would reduce the need for fiscal support for recapitalisation. Also, when the exchange rate is either stable or appreciating, there is complacency on those with forex liabilities and the risk of unhedged exposures goes up. This could become disruptive of markets, when there are sudden and large outflows.

While there are no easy solutions to the challenges of dealing with large capital flows and the impact of such flows on the forex markets, one has to note that in the recent months, there has been a reversal of flows from equity markets and as the US rates start heading up, there may be significant outflows from debt markets. The response at that time should be to allow the correction in the rupee to take place so as to restore a reasonable real effective exchange rate.

Another intractable challenge is that of the transmission mechanism of monetary policy. Banks price their loans on the basis of their base rates that are usually driven by the cost of funds. This implies that when policy rates are brought down, there is a lag before banks reduce their lending rates and even then, they may not necessarily reduce rates for existing borrowers. Yesterday’s policy — for the first time — talks of linking lending rates of banks to an external benchmark and having quarterly resets. This could have profound implications on the way banks operate. The report of the RBI Study Group on the MCLR system is keenly awaited.

The writer is a former Deputy Governor of the RBI . Via The Billion Press

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