Opinion
Indian monetary policy and the fine art of acting without acting
Summary
RBI may have effectively set the course for slightly higher credit costs without making changes in its benchmark policy ratesThe Reserve Bank of India (RBI) wears many hats, but its role as a monetary authority has an outsized influence on the economy. Under that embodiment, it has a somewhat dilemmatic mandate —maintaining price stability while fostering growth—which often requires it to dissemble while communicating policy frameworks to markets. The art of central-bank speak essentially entails speaking a lot, but not saying much, and occasionally deploying sophistry to camouflage policy intent. The central bank’s latest monetary policy may have also used a visual trick: what you see is not what you get.
RBI’s October 2023 monetary policy has hewed close to the street consensus, leaving the repo rate unchanged at 6.5%. The stance of the monetary policy is also unchanged: “focused on withdrawal of accommodation to ensure that inflation progressively aligns to the target, while supporting growth." There are three ideas in here: withdrawal of accommodation implies liquidity in the system will remain surplus and RBI will continue to drain it out, aligning inflation with its 4% target, and growth support through credit availability. While all these seem boiler-plate in nature, the central bank may have effectively introduced a rate hike (or dearer credit) without increasing benchmark interest rates.
Here is how. In the lead-up to the policy announcement, most news headlines and analyst reports focused on the repo rate and RBI’s liquidity play. But with the inflation rate exhibiting what monetary policy committee member Jayanth R. Varma calls “monthly gyrations," it might be instructive to take a look at the real repo rate. At the end of August, interestingly, the real repo rate was minus 30 basis points (bps) when inflation based on the Consumer Price Index had clocked in at 6.8%; but given that monetary policy must be forward looking, using RBI’s projections for price movement, the real repo rate works out to 90bps in the October-December quarter and 1.3% in the January-March quarter. Assuming that RBI keeps repo rate untouched till March and its inflation guidance hits the mark, the real rate seems set to move from minus 30bps to 1.3%, or a journey of 160bps in just seven months.
There is one wrinkle that could derail this scenario: while it is unlikely that RBI will raise rates given the series of elections over the next 6-7 months, all bets will be off if it instead cuts rates early in the cycle.
If this seems too simplistic or a flawed argument, there is another way of looking at rates. Given RBI’s policy stance, and the temporary deployment of an incremental cash reserve ratio, the system went from liquidity surplus to liquidity deficit temporarily, forcing many banks to borrow short-term from RBI under the marginal standing facility (MSF), which extracts a higher interest rate of 6.75%. According to the October monetary policy report, MSF window borrowings averaged ₹29,287 crore during April-September, hitting a peak of ₹198,730 crore on 21 September. Subsequently, RBI’s liquidity operations show that banks have borrowed an average of over ₹125,000 crore every day under MSF for the seven days between 25 September and 1 October. While this spike might be temporary and reflective of banks unable to plan for flux in system liquidity, it might be worth asking whether banks will try to pass on this temporary cost to borrowers. Given that RBI will continue to suck out surplus liquidity, and that many banks will still queue up outside the MSF window for tiding over temporary cash flow imbalances, there is a likelihood that the MSF rate could become the effective benchmark rate. The weighted average call money rate has already moved up from 6.44% on 8 September to 6.75% on 29 September.
There are also indications that RBI’s complaints of incomplete rate transmission might be heeded via the bond market. The central bank announced that it will deploy open market sales of government bonds, as an additional instrument, to soak up surplus liquidity in the system.
Open market operations might have become necessary given the seeming misalignment between RBI’s liquidity absorption strategy and tools, and the banking sector’s liquidity calculations and other aspirations. The bond market reacted to the news with the benchmark 10-year G-Sec yield jumping 13bps to 7.34%, a considerable spike in a single day. If this spurt is not transient and not extinguished pre-maturely by RBI, then there is a faint likelihood that higher bond yields could translate into higher lending rates; the transmission path for this is likely to be indirect and uncertain because few banks use the 10-year government bond yield as an external benchmark.
In the midst of all the dissimulation, it is clear that RBI is walking on egg-shells: with intransigent inflation prints, slowing growth and surplus liquidity swirling around in the system, the central bank has to be mindful that its actions do not dim festive fervour nor jeopardize pre-election activities.
RBI’s anxiety is evident from the caution it has issued to banks and finance companies on the spurt in unsecured personal loans. It has been evident for a while, even though RBI failed to heed warnings, that a significant proportion of unsecured consumer credit, or even loans secured against fixed deposits, may have been routed to capital markets for speculative activity, assisted by unregulated fintech intermediaries. RBI seems to have woken up now; the last thing its balancing act needs is a threat to financial stability.
