The last monetary policy review, the first conducted after the Monetary Policy Committee (MPC) was constituted, saw a cut in the repo rate by 25 basis points. The move surprised many and was seen as a calculated gamble on the part of the Reserve Bank of India (RBI). That is because there were a number of imponderables on the horizon, including uncertainty around what the US Federal Reserve might do and the continued reluctance by banks to pass on rate cuts to borrowers despite adoption of a new marginal cost-based lending rate mechanism. There were some additional risks after India’s “surgical strikes” along the Line of Control with Pakistan. Yet, the decision was taken unanimously because there was some semblance of order, with retail inflation declining sharply and expectations of a growth revival on a consumption boost provided by a good monsoon and the Seventh Pay Commission payouts. But as the MPC sits down next week for its second review, those uncertainties will pale into significance. Thanks to the demonetisation of high-denomination currency notes, most previous calculations and assumptions need recalibration.
Banks are now flooded with liquidity; there is a real uncertainty about near-term growth in India; the narrowing differential between Indian gilts and US treasuries has led to massive outflows; and the rupee has been volatile, though it has fared better than other emerging market currencies. As such, a lot of other variables have gained prominence, liquidity management being the central concern this time. Since demonetisation, deposits have soared and RBI has had to employ extraordinary means such as resorting to raising, with retrospective effect, the incremental cash reserve ratio (CRR) to 100 per cent for all net demand and time liabilities since September 16. It did so after exhausting all avenues of soaking up liquidity through the use of government bonds under the Market Stabilisation Scheme (MSS). Estimates suggest that between the CRR move and the use of government bonds, RBI is estimated to have the wherewithal to suck out about Rs 10.2 lakh crore from the banking system.
RBI was forced to soak up this liquidity partly because it does not want banks to use it to lend to possibly risky ventures and partly because when the demand deposit withdrawal limit is relaxed, this money is likely to flow out. But this is coming at a cost of banks’ short-term profitability because no interest is being paid to banks on the incremental CRR move. Ideally, the RBI and the government should shift to using MSS bonds by raising the limit for this year. But doing so will adversely impact the fiscal deficit target of 3.5 per cent of the gross domestic product (GDP).
On the repo rate, it is not a straightforward decision to cut it. That is because, it is unclear how demonetisation will affect overall supply and inflation in the immediate period. Moreover, a cut could place RBI behind the curve, given there is more than a 90 per cent chance of the Fed raising rates by 50 to 75 basis points when it meets in mid-December. Yet, with second-quarter GDP growth being below expectations and the third quarter expected to be slower, RBI might be forced to cut rates to spur growth with little apprehension about an inflationary flare-up.
