Global macroeconomic conditions are improving gradually. Normalisation of monetary policy is under way, led by the US Fed. Compression of yield rates of fixed income securities seems to have bottomed out. Turnaround of interest rates in major advanced economies is the logical outcome of the monetary policy normalisation. Would it pose serious policy challenges to emerging and developing economies (EDEs) such as India?

Short-term capital flows such as portfolio investment by FIIs, hedge funds, venture capital and private equity flows are sensitive to interest spread between developed and developing countries. In the aftermath of the announcement of taper tantrum, EDEs suffered a setback due to sudden flight to safety based on the perception of a probable rise in interest rates in developed countries. Would this be repeated in the process of monetary policy normalisation going forward? Going by the principle of ‘once bitten twice shy’, central banks in EDEs are generally extra-cautious. However, one can argue that global capital flows depend on country-specific factors and therefore, broad generalisation may be inappropriate. The fallout of monetary policy normalisation in developed countries may not be as pervasive as the US taper tantrum announcement in 2013.

Benign pressure

Back home, while switching gears from accommodative to neutral monetary policy stance in February 2017, Monetary Policy Committee members cited both domestic and global factors that are likely to evolve over time. While the normalisation of the monetary policy is on a slow track, the inflationary pressure in the domestic market is more benign than anticipated. Economists have started questioning the neutral monetary policy stance in India is appropriate in view of the sustained surplus liquidity condition, negative output gap and low CPI inflation excluding the impact of hike in the house rent.

Following demonetisation, deposit growth suddenly accelerated amidst poor offtake of credit. As a result, short-term money market rates, particularly overnight rates, crashed below the reverse repo rate on many occasions. In the absence of adequate government securities in its portfolio, the RBI was forced to hike incremental CRR by 100 per cent for a brief period.

Excess liquidity

As soon as the Government authorised the RBI to issue g-secs under the Market Stabilisation Scheme (MSS), the CRR hike was rolled back. The issuance of MSS securities involves cost to the exchequer. Currently, the RBI is struggling to suck out excess liquidity by using a variety of instruments such as Open Market Operations (OMOs), cash management bills, MSS securities, auction term reverse repos and fine-tuning operations on a daily basis at variable rates besides the usual fixed rate reverse repo. In the absence of a standing deposit facility, which requires amendment of the RBI Act, liquidity management will continue to face serious challenges under extreme situations.

In order to cope with the excess liquidity conditions, the RBI reduced the corridor from plus/minus 50bps to plus/minus 25 bps around the repo rate but maintained neutral monetary policy stance on April 6, 2017. The RBI did not change the stance of monetary policy in June as well as in August 2017, although repo rate was cut by 25 bps on August 2, 2017.

Despite normalisation of the US monetary policy, capital flows to India continue to remain robust due to strong medium-term fundamentals. With India attracting a large amount of foreign direct investment which can finance CAD, is there a case for maintaining adequate interest spread between India and the US?

It is always better to avoid volatile capital flows, which can be achieved by pursuing a low domestic interest rate policy particularly when the CPI inflation is well under control and the output gap is negative. This would help resolve the liquidity problem arising out of large capital flows and also benefit industrial recovery by reducing interest costs. In this context, growth advocates feel that the RBI changed gears from accommodative to neutral a little too early and the recent cut in repo rate by 25 bps was too little to stimulate growth.

The ideal scenario

Ideally, a neutral monetary policy stance should be preceded by a neutral liquidity condition in the market so that implementation of monetary policy becomes smooth. The decision to change the monetary policy stance from accommodative to neutral was taken at a time when the liquidity condition was excessively comfortable.

Many analysts thought that excess liquidity in India was a transient problem — a fallout of demonetisation. As excess liquidity persists for a longer period, it seems to be an enduring problem, more appropriately a structural problem with deposit growth exceeding credit growth by a wide margin. Large capital flows into India complicate the process further. The RBI is not in a position to freely intervene in the spot forex market to check large rupee appreciation as it would further add to excess liquidity.

Net absorption under liquidity adjustment continued to remain high around ₹3 trillion for quite some time; this is being rolled over through a variety of instruments on a regular basis except a few outright OMO sales in the recent period. It appears as if India’s monetary policy stance is not in sync with liquidity condition. What happens if monetary policy stance and liquidity conditions are not in sync? Does it adversely affect monetary transmission?

When banks are typically not borrowing from the RBI, they do not benefit from the repo rate cut. The impact of the recent repo rate cut remains muted at the first stage of transmission itself. Expecting banks to transmit the signal further is futile. Banks take this opportunity to cut deposit rates further and may oblige by a token lending rate cut in certain segments later.

The writer was principal adviser and head of the monetary policy department, RBI