Monetary Policy: RBI talk may be as important as its walk

In a few hours India’s fledgling monetary policy committee (MPC) will announce its sixth monetary policy. The first year of the MPC has been a tumultuous one. In the best of times forecasting India’s GDP growth and inflation is a tough exercise.

But in the past year, this forecasting has been rendered nigh impossible with the sovereign suddenly extinguishing 85 percent of the currency. And then, as one disruption settles down, another begins: the country has begun implementing a most ambitious single national indirect tax structure replacing and collapsing tax rates of 30 different states.

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And as if this were not enough, the domestic economic drama is paying out in the midst of unprecedented volatility in the world’s most used currency, the dollar. For the record, the dollar index or the DXY rose 12 percent from Nov 8 2016 to Jan 2017 and then fell 12 percent by July.

That said, the MPC has to own up to some decisions that have, on hindsight, turned out to be hasty. For instance, the movement from accommodative to neutral stance in February. Inflation readings since that date have fallen sharply in part because of delayed consequence of demonetisation. The MPC reluctantly diluted its stance in the June policy and put forth sharply lower inflation forecasts. But the consumer inflation in the subsequent months have come in even below these sharply lowered forecasts.

Under the circumstances the RBI perhaps would have any ways given a rate cut in August. But once again the pitch has been queered for the MPC ahead of its August policy. Just 48 hours earlier the country’s biggest bank, SBI, slashed its savings deposit rate. Slashing of the savings deposit rate is far more historic and far reaching than a repo rate or a term deposit cut. For most large banks like SBI, savings deposits form 35 percent of their deposits, and a cut affects the entire pool (of 9.5 lakh cr) unlike a term deposit rate cut which affects only incremental deposits. And then it is a 50 bps cut, not an incremental 25.

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The SBI cut puts RBI in a quandary. Can it stay on pause when only 48 hours ago the banking sector has emphatically declared it is moving in the other direction? To be sure the inflation assessment of RBI and some of the constituent banks can be different. That said, it can't be denied the SBI cut limits the MPC’s options severely. Lending rates in the system are sure to fall even if RBI doesn’t give a rate cut. A conspiracy theory is that the government used the public sector banks to have its way on lower rates, in the face of a hawkish MPC. But the counter argument could be that the RBI always maintained that while it is moving to a neutral position, there is always space for banks to transmit more, and hence, the SBI need not be seen as contrary to the MPC stance.

In part, SBI’s action is because of the dichotomy between RBI’s talk and walk. While RBI moved its policy stance from accommodative to neutral, its liquidity stance since October has remained overwhelmingly accommodative, even after the change in stance in February. On average, there has been around Rs 2.5-3 lakh crore of surplus cash in the banking system which the RBI has had to absorb through fixed and variable rate reverse repos. The RBI can’t be entirely blamed for this overwhelming surplus liquidity.

Demonetisation increased the liquidity in the banking system by about 8 percent in 8 weeks, even as lending declined sharply in part because of demonetisation. As if this were not enough, starting March foreign funds flows into emerging market debt have returned with unprecedented ferocity, thanks to the weakening dollar. Also, the government decided to advance its budget, making available huge liquidity into the system because of early and voluminous spending by ministries.

The contradiction between a loose liquidity policy and a neutral monetary policy has led to the current contradiction where the regulated entities have moved to accommodative positions, even while the regulator is at a neutral policy stance.

The MPC’s pain doesn’t end here. The extra liquidity and the simultaneous crash of prices of real estate and gold due to global factors and the domestic demonetisation have driven more liquidity from gold, cash-in-hand and land into financial assets. Abetted by global fund flows, stock indices and fixed income instruments have been rising to dizzying heights. Indian stocks, even after assuming an 18 percent rise in earnings, are trading at 20 times which is way above mean valuations (though lower than the 25 times that they traded during the GFC).

Likewise, with non bank finance companies and debt mutual funds bursting with cash, experts fear credit standards have become stretched and companies that could never have raised loans at single digit rates are now easily getting money for 8 percent, while commercial papers are being floated these companies for much less.

Under the circumstances, can the RBI nonchalantly cut rates and effectively be a cheerleader? Even if a cut has been forced it may well want to use macro prudential instruments to curb lending to some sectors expensive. Secondly, the RBI can indicate that it will drain liquidity more assiduously, especially if inflation starts picking up. It has already sought permission to issue 2 lakh crore more of Market Stabilisation bonds. It may also see slower government spending in the rest of the year, what with the bulk of the spending happening in the first 6 months.

Finally, the MPC can say it will remain resolutely data-dependent. This far the RBI has cut rates only after inflation fell, and not in anticipation of price falls. It may well sound truly neutral in the policy and indicate it will cut further only if and after the date undershoots.

So that’s what India Inc will watch: the action on rates, the outlook on inflation, any tweaking on risk weights and provisions on loans to "risky" sectors, any express worries on market exuberance and any hints on liquidity.