Post-demonetisation, the challenges before the Reserve Bank of India are manifold. These include: (a) the logistics of managing the printing and distributing of new currency; (b) shredding the large volume of old currency; (c) managing the unprecedented rupee liquidity; (d) arresting the volatility of the exchange rate through intervention; and, more importantly, (e) ensuring the appropriate short-term interest rate through signalling in the policy repo rate, by the resolution of the Monetary Policy Committee (MPC) which will be announced on December 7.

Falling bond rates

The RBI has engaged what may be termed the ‘holy trinity’ of instruments comprising (a) reverse repo operation (both fixed and variable as also overnight and term segment) under its Liquidity Adjustment Facility (LAF), (b) incremental Cash Reserve Ratio (CRR) and (c) 28 days Cash Management Bill (CMB) under the Market Stabilisation Scheme (MSS).

It may be recalled that the Urjit Patel Committee had, however, strongly recommended that CMB as an instrument should be discontinued. The exigencies of demonetisation and unprecedented rupee liquidity compelled Governor Patel to eat his words and introduce the CMB. The RBI may claim that this time is different.

On account of this triangular intervention through the ‘holy trinity’, the interest rate at the short end has hardened. The weighted average call rate (WACR) , the operating target of monetary policy framework moved to 6.13 per cent on December 2 from less than 5 per cent soon after the November 8 demonetisation announcement. The CMB cut-off rate was 6.13 per cent on December 2. The variable reverse repo rate was 6.24 per cent. The 10 year bond yield rate was 6.28 per cent. The rupee-dollar rate depreciated to 68.46.

Going by the objective of introducing a cashless economy and considering the cost of printing, it is expected that RBI will not be encouraged to print the entire amount of Specified Bank Notes (SPN) which have been withdrawn from circulation. It will possibly print no more than 70 per cent of this currency to maintain a currency growth of 11-12 per cent, in line with the nominal GDP growth (real GDP plus inflation). Even this amount of printing is time consuming, and therefore could go well beyond December 30.

Costs of demonetisation

The banking sector is waking up to the costs of demonetisation. There will be a net additional cost to the banking system in terms of huge deposits received from the system, but the RBI will not pay any interest rate on the CRR as per the RBI Act. The MSS borrowing through CMB will be an additional cost to the government and a drain on the budget. In all the permutations and combinations, the RBI balance sheet will remain unaffected and there will be no windfall gain to the government. Rather, there will be an interest cost to government in terms of MSS. Thus, demonetisation in net terms is a burden on the citizen and more so on the common man. It imposes an interest burden on the banking system and the government, resulting in higher revenue deficit and dissavings of the government. This will, in turn, will have an adverse impact on growth.

Against the above backdrop, should there be a repo rate reduction on December 7? The market has already taken for granted that the RBI will go for a rate cut. This is dangerous groupthink and the MPC will be well advised not to fall prey to it.

Focus on normalcy

Rather than a cut, the implications of which are not fully understood in the midst of the chaos and uncertainty caused by demonetisation, the priority now should be to restore normalcy by smoothening the process of liquidity management. The focus should be on enhancing the currency note availability and removing weekly and daily restrictions on withdrawals. The business environment is not encouraging at present.

Furthermore, the expectation of an increase in the US Fed funds rate looms large. The policy repo rate reduction will have a negative impact on the bond rate and other long term rates rather than ease the lending rate of banks. This is because the time lag in the transmission to the lending rate is longer than the transmission to bond rates.

A lower interest rate will encourage further outflows of portfolio investment. As the evidence suggests, in November, more than $6 billion have exited the bond and equity markets. One is not sure whether the transmission channel will gear up to the desired level as far as the credit market is concerned.

In the current milieu, it is not the availability and cost of credit but the psychology and business sentiment that is important — what John Maynard Keynes termed the “animal spirits”. In addition, there are uncertainties on growth outlook not because of cost and availability of credit but because of non-payments to the labour force, particularly agricultural labour, and lower consumption in rural areas.

It is, appropriate, therefore, that the RBI/MPC should refrain from a policy repo rate reduction. Since currency and liquidity management are core central banking functions, the onus is on the RBI to make the transition to normalcy smooth and painless.

We have great confidence in the technical staff of the RBI and the hope is that the MPC will be correctly advised by the RBI team. The RBI and MPC should not give in to what is being projected as market sentiment. It is time to recall Raghuram Rajan’s famous comment: “The RBI is not a cheer-leader.”

Pattnaik is a professor of economics at SP Jain Institute of Management and Research. Rattanani is the editor of SPIJMR. Via Billion Press