As expected by virtually everyone, the Reserve Bank of India (RBI) decided to maintain the status quo on policy rates. The rationale for this was articulated by Governor Raghuram Rajan several days ago. Notwithstanding the recent moderation in inflation, the RBI still sees upside risks as being significant, particularly from food. The monsoon was below normal, resulting in a possible slowdown in growth of kharif output. Although prices have not spiked across the board yet, the likelihood that they might as the harvest comes in is significant. Until that threat abates, Governor Rajan believes that it is better to be safe than to flip-flop on the policy rate. Importantly, though, this concern is not just about the immediate future; the inflation projections reported in the policy statement indicate upside risks to the March 2016 target of six per cent consumer inflation. The implicit, but clear, message to the government is that the space for monetary stimulus will only expand when robust long-term measures to reduce and contain food inflation are implemented.
With the monetary policy announcement being essentially a non-event, attention must inevitably turn to the regulatory component of the policy statement. Several potentially significant initiatives have been announced. Under the pillar of financial market development, the RBI is continuing down the path of reducing the held-to-maturity (HTM) proportion of the government securities portfolios of banks. This component will go down in stages from 24 per cent of net demand and time liabilities to 22 per cent. The exemption that banks have been provided from mark-to-market requirements on the HTM portfolio is a major deterrent to the development of a genuine secondary market for government securities. Steadily eliminating the exemption is a critical requirement for market development, and the step is, therefore, welcome. However, the concern is that in its anxiety not to be disruptive, the pace of adjustment is just too slow. Another important step is to bring urban co-operative banks, which fulfil certain requirements, into the ambit of liquidity adjustment facility (LAF). This will enhance the stability of this segment of the industry, which plays an important role in the financial inclusion mission. Innovations in the repo market, which will permit a secondary market to emerge in repo-ed securities, will add to the efficiency of banks in meeting their prudential requirements.
As regards financial inclusion, the statement commits to the issue of licences for payments banks and small banks in a few weeks. Time will tell whether these new segments offer attractive business opportunities. More concretely, though, some flexibility has been introduced in the always onerous know-your-customer (KYC) process; no dilution of requirements, of course, but imposing a one-time-only requirement across the banking system as opposed to each bank doing its own due diligence. On financial stability, the most significant problem that the banking system faces is that of asset quality. While better growth prospects - the RBI projects growth during 2015-16 to accelerate to 6.3 per cent from 5.5 per cent this year - will relieve some of the stress, more rigorous mechanisms relating to early warning, more granular supervision of stressed banks, a centralised database of defaulters and so on should enhance stability.
