Beyond rate cuts

RBI's focus now is on improving transmission and lending

The decision of the monetary policy committee (MPC) of the Reserve Bank of India (RBI) to leave the policy rates unchanged is in line with market expectations. The evolving inflation dynamics played a key influencing role. Inflation based on the consumer price index jumped sharply to 7.4 per cent in December. While the vegetable prices, especially those of onions, have come down from their December highs, the decline in the inflation rate could be restricted in the near term by higher prices of pulses and other protein items. The adjustment in telecom prices is also putting cost-push pressure on core inflation, though it remains close to the 4 per cent mark.

The MPC has noted there is policy space available for future action. The central bank expects the inflation rate to come down to 3.2 per cent in the third quarter of the next fiscal year. Although there is significant uncertainty, if inflation moderates in line with the RBI’s projection, it may be able to reduce policy rates by another 25 basis points, taking the repo rate to 4.9 per cent, which could become the floor. Supporting growth through monetary policy beyond that would become extremely tricky. More space can perhaps open up in the case of larger than expected disinflation, partly because of deceleration in global growth on account of coronavirus. The central bank expects the Indian economy to grow at 6 per cent in the next fiscal year. 

Since the space for further monetary easing is fairly limited, the central bank is now focusing on transmission and increasing lending. For instance, it has given relief to banks in maintaining the cash reserve ratio against loans for automobiles, residential housing, and micro, small and medium enterprises (MSMEs) till July 31 this year. The central bank has also extended the one-time restructuring scheme for MSMEs and relaxed the rule for asset classification in commercial real estate. The RBI further decided to introduce external benchmarking of loans by scheduled commercial banks to medium enterprises from the beginning of the next fiscal year. Apart from these interventions, the central bank will conduct long-term repo of one-year and three-year tenor worth Rs 1 trillion to infuse more money into the banking system and bring down the lending rates. Policy transmission has been slow in the case of long-duration bonds and bank-lending rates. Yields on 10-year government bonds, for instance, came down by 76 basis points till January 31, compared with the policy rate reduction of 135 basis points. 

On balance, the set of policy interventions announced by the central bank on Thursday is intended to improve transmission and incentivise the banking system to lend. But whether these measures would improve lending remains to be seen. For instance, extending the external benchmarking could affect interest margins of banks because the deposit rates are sticky. Also, though yields came down after the announcement, it is not clear as to what extent the long-term repo will help the banking system when the liquidity is surplus to the tune of over Rs 3 trillion. The longer-term rates are proving to be stickier because of higher government borrowings and declining household financial savings. The government now wants to import more savings by issuing special securities to non-resident investors. While this will potentially help reduce the cost of money, it can increase challenges for the central bank in currency and liquidity management.