RBI monetary policy: MPC goes for normalisation by stealth

There was no surprise in the outcome of the three-day meeting of the monetary policy committee (MPC) of India’s central bank — one that ended on Wednesday — the last before the Union Budget for the next fiscal year.

The policy rates remain unchanged and the stance stays accommodative even though Reserve Bank of India (RBI) Governor Shaktikanta Das said that India is “better prepared to deal with the invisible enemy COVID-19” and “in several sectors of the economy, pre-pandemic levels of output have been crossed”. The repo rate, at which the RBI infuses liquidity, remains 4 per cent and the reverse repo rate, at which it sucks out liquidity, 3.35 per cent.

Very few had expected the RBI to raise the rate or change the stance but the undertone of the policy, many are saying, is more dovish than the expectation. Is that so? I have a different take on this. Beneath the ultra-dovish undertone, the RBI has actually strengthened the normalisation process, started in October, by stealth. There is a subtle but significant change in the way the RBI plans to manage liquidity in the system.

Besides the reverse repo window, the RBI has been using variable reverse repo rate (VRRR) auctions to drain out liquidity. The amount of such auctions, progressively hiked to Rs 6 trillion in the first week of December, has been raised further to Rs 6.5 trillion in mid-December and Rs 7.5 trillion by month-end. From January 2022 onwards, liquidity absorption will be undertaken mainly through this route.

From one of the many tools to drain out liquidity, the 14-day VRRR auction is being positioned as the main instrument for this purpose. The weighted average rate for such auctions is now 3.8 per cent. Essentially, the RBI is making the 3.35 per cent reverse repo rate redundant even as the VRRR auction continues to raise the short-term rates of all money market instruments.

This is a smart way of raising the market rates without hiking the policy rate. The bond market also has no reason to complain. The 10-year bond yield dropped from 6.39 per cent to 6.34 per cent after the policy announcement.

This will also encourage banks to arbitrage between the overnight money market and tri-party repo, or TREPS, and the VRRR. Tri-party repo, introduced in November 2018, replacing collateralised borrowing and lending obligation, is a type of repo contract where a third entity —apart from the borrower and lender — acts as an intermediary to facilitate selecting collateral, payment/settlement, custody and managing transactions.

The overnight money market and TREPS rates have been varying between 3.25 per cent and 3.30 per cent. The banks can borrow here and earn higher rates, lending the money at VRRR auctions. Typically, mutual funds, insurance companies, and Indian corporations are lenders at TREPS. Both the overnight money market and TREPS rates will rise now.

Noting that the recovery of the Indian economy is gaining traction, the RBI has kept its real GDP growth estimate unchanged at 9.5 per cent for 2021-22 but the way it is looking at growth has changed. Till the last policy, the central bank had been focusing on securing growth on a sustainable basis. Now, the focus has shifted to making it “broad-based”.

“Given the slack in the economy and the ongoing catching up of activity, especially of private consumption, which is still below its pre-pandemic levels, continued policy support is warranted for a durable and broad-based recovery,” the statement said.

It has expressed its concern over the persistence of high core inflation (inflation excluding food and fuel) but kept its retail inflation projection unchanged at 5.3 per cent for 2021-22 -- 5.1 per cent in the third quarter and 5.7 per cent in the fourth, with risks broadly balanced. This is a surprise as most analysts see retail inflation at around 6 per cent in the fourth quarter.

What is the guidance of the central bank? Clearly, the bias is towards growth and it says so with candidness: “We remain committed to our stance in support of our overarching priority at this juncture to broaden the growth impulses while preserving monetary and financial stability.”

The recovery that had been interrupted by the second wave of the pandemic is regaining traction but the RBI does not see this strong enough as yet to be self-sustaining and durable. This is why it will continue to lend policy support to growth and all actions will be calibrated to “ensure a soft landing that is well timed”.

When will we see a rate hike? Will it happen in February? In the post-policy interaction with the media, Michael Patra, deputy governor and MPC member, said the output gap would take years to close. A rate hike could be still some distance away.

When the next MPC meets in February, it will have the fiscal deficit figures as well as the next year’s government borrowing programme on its table. By that time, there will be more clarity on the growth front. Still, it is difficult to predict whether we will see a reverse repo rate hike in February or whether it will be held over until April. A hike in the repo rate can happen only after that because the gap between the repo rate and the reverse repo rate or the so-called liquidity adjustment facility corridor needs to shrink first to make it effective.

The writer, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd. His latest book: Pandemonium: The Great Indian Banking Story. 

To read his previous columns, please log on to www.bankerstrust.in

Twitter: @TamalBandyo