RBI must now look to staunch the liquidity

As expected, the Reserve Bank’s Monetary Policy Committee kept the repo and reverse rates unchanged at 4 per cent and 3.35 per cent, respectively. It also decided to continue with the current accommodative stance of the monetary policy as long as necessary, at least till the current financial year and into next year. Both the decisions were unanimous. This is the third time in a row that the MPC has decided to maintain status quo.

The stock market welcomed the policy announcement, with the Sensex touching the 45K level mainly because of the MPC’s positive assessment of growth in H2:2020-21 and beyond. The yield on the benchmark 10-year G-Sec remained more or less unchanged at around 5.90 per cent.

Revival with inflation worries

The MPC expects the real GDP growth to be positive from the third quarter of 2020-21 onwards, with a decent rebound in the first half of 2021-22. Its projection for 2020-21, as a whole, is (-)7.5 per cent. Against the backdrop of the CPI inflation rising to 7.3 per cent in September and further to 7.6 per cent in October, the MPC expects it to be lower at 6.8 per cent in Q3 and 5.8 per cent in Q4. However, in MPC’s words, “inflation is likely to remain elevated, barring transient relief in the winter months from prices of perishables”.

The RBI’s strategy in the wake of the Covid-19 outbreak to deal with the unprecedented supply and demand shocks and their impacts has had the following broad elements: (a) pursue extra-loose monetary policy by aggressively cutting policy rates, thereby taking the real rate into the negative territory, (b) infuse liquidity on a scale and with a speed not witnessed before to keep the wheels of the economy well-lubricated and provide low-cost funds to certain targeted troubled sectors, and (c) to intervene in the government securities and SDL market in the recent weeks to provide support to the borrowing programmes of the Central and State governments. Another element that has been added since MPC’s October meeting was to remove uncertainty about any possible policy reversal in the near future, in view of the recent upsurge in inflation, by providing deterministic guidance in this regard.

Is this strategy working? India’s growth impulses were weak at the onset of the pandemic and the health of its financial sector was far from rosy even then. The impact of the shock in the first quarter of 2020-21 on growth and the fiscal was way worse than India’s main peer countries.

Also, in the post-Covid months, India’s CPI inflation has been consistently higher and the real interest rate lower than of China, Brazil, South Africa, Indonesia and most other G-20 countries. This needs to be analysed and understood comprehensively, before the revival of growth is attributed to the success of the strategy in a cause-and-effect sense. As regards financial markets, the RBI has already congratulated itself, stating that it has acted proactively and nimble-footedly to ease financial market conditions and mitigate/contain near-term financial risks with a slew of conventional and unconventional measures.

But the mainstay of the RBI’s measures has been to create a deluge of liquidity, the daily overhang of which was ₹7.35-lakh crore as of December 3. One important dimension of this phenomenon has been that while the reserve money grew, as a consequence, at a very fast pace, transmission of such expansion to the real economy has been muted so far, as the growth in broad money lagged far behind, due to a sharp drop in money velocity. Again, the sluggish growth in credit offtake witnessed before the pandemic has persisted, and perhaps worsened in the recent months. Here again, India’s numbers do not look impressive at all in comparison to its peers. Despite the ‘feel good’ sense engendered by the positive growth outlook and remarkable stock market buoyancy, the country’s stressed financial sector and MSME space will continue to hinder growth revival.

A sense of uneasiness over the huge liquidity surplus is slowly developing in the market. Apart from the usual medium-term adverse macro impacts of such an occurrence by way of higher inflation, several micro possibilities like diversion of funds from banks and NBFCs to high-risk and unauthorised deployment avenues involving equity, real estate, commodities etc. now exist. Also, there is a deeper issue here. While their ability to create ample liquidity in crises is one of the reasons why central banks exist in the first place, the manner in which this bounty is created by way of intervention in the financial markets is also important, as mispricing of financial risks could very well be an offshoot of such interventions.

Growing concerns

By all indications, the RBI’s market operations in the recent months, through OMO auctions or otherwise, have been mainly aimed at facilitating the Centre’s borrowing and debt management efforts. But are the current yields of the government securities, particularly of those with long tenors adequate from an economic risk-return perspective? Apparently, the same applies to the credit market as well, with the yield on 10-year triple-A rated corporate paper now around 6.70 per cent — more or less the same as that of a 10-year SDL.

This apparent mispricing of risk is perhaps one of the reasons for the financial sector’s reluctance to make available to the real sector the cheap money received from the RBI. It will not be sufficient to term the recent spurt in inflation as ‘temporary’. The RBI would do well to start thinking on how to roll back the liquidity surge in a non-disruptive manner.

The RBI has announced its plans to review the regulatory framework in line with the changing risk profile of NBFCs. A differentiated regulatory regime for NBFCs, termed ‘scale-based regulatory approach’ linked to their systemic risk contribution is going to be the way forward. A detailed perspective on this approach was provided by a top official of the RBI about a month back.

Between 2009 and 2019, the total assets of NBFCs grew at about twice the annual pace at which banks’ total assets grew during this period. NBFCs’ aggregate balance-sheet size increased from 9.3 per cent to 18.6 per cent of banks’ aggregate balance-sheet size during that time. Some of them became competitors of banks, even as they were heavily dependent on banks for their funds. Barring a few large NBFCs, all others have either asset-liability mismatch issues and/or asset quality issues.

All in all, NBFCs will not be competing with banks in the foreseeable future. It is easy to say that NBFCs play a supplemental role in providing credit. But this has been a nice-sounding wish so far, for the simple reason that the efficiency of their financial intermediation has been lacklustre. One has heard these gratuitous visions of financial institutions in the co-operative sector for a long time.

The highest annual return on equity (RoE) of the deposit-taking and non-deposit taking but systemically important NBFCs during the four financial years to end-March 2020 was only 6.8 per cent. Quite obviously, the new regulatory approach should incentivise the continuance of those NBFCs whose business model can keep operating costs significantly lower than banks and which can deliver a minimum pre-determined risk-adjusted return on economic capital in a sustained manner.

The writer is a former central banker and consultant to the IMF (Through The Billion Press)

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