Apr 06, 2017 09:23 PM IST | Source:

RBI policy perfect: A tough road lies ahead

Reserve Bank spared the already beleaguered banks any further burden in its effort to suck out excess liquidity from the banking system, yet it tempered its kindness with a stern warning on inflation.

Latha Venkatesh

The Reserve Bank delivered a near perfect policy. It spared the already beleaguered banks any further burden in its effort to suck out excess liquidity from the banking system, yet it tempered its kindness with a stern warning on inflation.

Here is RBI’s problem: It is an inflation-targeting central bank which only recently moved its stance from accommodative to hawkish. Yet many treasury bills (T-bills), till before the policy, were trading at 5.75 percent-6 percent, way below the repo rate of 6.25 percent largely because of the huge excess cash with banks.

The falling yields dented RBI’s inflation fighting credentials.

One way to suck out the liquidity was to raise the cash reserve ratio (CRR). CRR is the percentage of their deposits that banks must keep idle with RBI. A rise in CRR would have raised banks’ costs sharply.

RBI didn’t hike the CRR yet deftly handled the conundrum. It raised from 5.75 percent to 6 percent the reverse repo rate—the rate at which RBI takes idle money from banks. Instantly all T-bills trading below 6 percent jumped up and came closer in line with the repo rate.

The higher reverse repo rate also puts a little more money in the hands of bankers, who need a lot of cash to provide for bad loans. More importantly, this move has ended the fear of a hike in CRR.

Secondly, the RBI sounded the right amount of caution on the coming inflation challenge. Yes, the February reading at 3.65 percent is 260 basis points below the policy rate.

But with an El nino warning, the usual summer rise in food prices could get worse. Also, brace for vegetable shortages, if farmers who suffered losses when veggetable prices crashed due to demonetisation, move away to other persuasions. Sugar, fruits, meat and milk have already become pricier.

Crude prices while not rising aren’t falling much either. With metal prices rising and some reflation in Europe, producers are close to getting back some pricing power.

As the RBI executive director put it, "there are no disinflationary sweeteners on the horizon".

RBI’s forecast for the second half of FY18 is 5 percent inflation, which is bound to worry an MPC tasked with bringing inflation down to 4 percent.

If achieving the 4 percent goal is spread out to FY19, we will probably get away without any rate hikes this year, but clearly from hereon rates are more likely to rise than not. RBI didn’t mince words in giving that message.

Nor did it mince words in showing its displeasure for loan waivers. It spoils the credit culture, raises expectations in neighbouring states, can send micro finance companies to ruin, and finally impose borrowers’ burden on tax payers. In the same vein, the RBI was stern about not allowing banks any leeway on providing from their profit for their bad loans.

Yes, it may allow some tweaks to rules governing restructuring loans and may allow more oversight committees that could give banks some cover from charges of cronyism when they sign off on loan haircuts to big defaulters.

All told, the policy was a great balancing act. It also left behind for markets a debate for a future date: How to structure the proposed Standing Deposit Facility?

This is a window at which banks can deposit idle cash with RBI without taking any collateral of G-secs. RBI’s ability to drain the post demonetisation cash surplus was capped by the amount of bonds in its kitty. RBI Act doesn’t allow the central bank to give or take money without collateral.

Once the Act is amended, RBI will get another tool. But bankers are divided on whether RBI will make the deposit mandatory, like CRR, but pay an interest. Or will it leave it as optional but pay less than the reverse repo rate. A lively debate is already afoot in bank treasuries.

Whatever the design, such a deposit gives the RBI nearly unlimited ability to buy dollars to stem the rupee appreciation. Currently, at a 18-month high, the rupee is now 22 percent overvalued in real effective exchange terms against a basket of 36 countries who are India’s top trading partners.

RBI’s intervention was this far crimped because if it bought dollars it added to the rupee surplus and didn’t have enough bonds to soak it. Now with this facility on the anvil, RBI needs to silence rupee bulls before a dutch disease begins to hurt Indian industry.
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