Optimal monetary policy means a policy that maximises the welfare of a representative agent, given frictions in the economic environment. India’s monetary policy unveiled on September 30 has precisely achieved this objective by raising the policy repo rate by 50 basis points (bps) but not changing the liquidity stance from the current gradual “withdrawal of accommodation”.
In fact, the Reserve Bank of India (RBI) has assured that it will fine-tune its liquidity operations of various maturities for absorption as well as injection of liquidity as may be necessary from time-to-time. This was the need of the hour, given the heighted nervousness in India’s bond markets, primarily triggered by the actions of global central banks, and their negative externalities.
There is no doubt that the frictions in the economic environment have increased multi-fold in the last two-and-a-half years. The dual shocks of COVID-19 and the Ukraine conflict have caused significant global economic disruption, fuelling stubbornly high inflation especially in the United States and the Euro area. The central banks of advanced nations are responding to this ‘inflation’ shock by aggressive monetary policy actions, and more aggressive communication. As stated by the RBI Governor on September 30, the necessity of such actions in advanced nations is driven by their domestic considerations, but emerging market economies are paying a price for that because of the negative spillover effects.
Hence, there was a strongly-felt need for India to carve its own monetary policy path that would help it manage the inflation and external sector stabilisation without stalling the process of economic recovery. The RBI has ensured this by fine-tuning its liquidity operations to suit the requirements of productive sectors. It has also added that as government expenditure picks up, supported by high GST and direct tax collections, the system liquidity will go up further. There has been a moderation in liquidity currently, and, therefore, the RBI has decided to merge the 28-day VRRR (variable reverse repo rate) auction with the fortnightly 14-day main auction. The RBI also remains open to short-term liquidity operations to manage liquidity, including overnight variable rate repo operations. Another comfort factor comes from the fact that banks do have excess holdings of CRR and SLR, which they may use to augment loanable funds.
While the MPC has lowered its GDP growth projection for FY23 to 7 percent from 7.2 percent earlier, it has retained its CPI inflation projection at 6.7 percent. This means the MPC clearly sees more risks to growth than to inflation. The MPC has listed extended geopolitical tensions, tightening global financial conditions and possible decline in external demand, as some of the downside risks to growth. However, moderation in global commodity prices augurs well for India’s inflation trajectory. This assessment of the growth-inflation mix must have helped the MPC to retain its liquidity stance at the gradual “withdrawal of liquidity” rather than an “aggressive tightening of liquidity”.
The other factor that has given additional elbow room to RBI is the reduction of Rs 10,000 crore in the borrowing target of the Union government for the year FY23. The monetary policy action combined with the “government’s reduced borrowing target” are bond market positive. The OIS rates for corporate bonds across the tenors declined today by 5-7 bps across tenors after the announcement of monetary policy. Rupee too gained sizably by 0.8-0.9 percent after the RBI increased policy repo rate by 50 bps for the third time since June. While the decisions of MPC were not unanimous, there was a majority of “five versus one” in both the “rate” and the “stance” decisions.
Besides the monetary policy decisions, the RBI has taken a few regulatory and developmental measures that will strengthen the balance sheets of the banking sector. Similar to what the NBFCs have been following, banks will now be subjected to a more prudent and forward-looking way of “expected loss based approach” for their loan loss provisioning. According to the rating agencies, this will encourage a few lenders to start building “provision buffers” to smoothen the transition. Fortunately, corporate stress cycle in India is mostly played out and banks have been making materially higher provisions than prescriptive norms.
Given the increased uncertainty in the global economic environment, and higher probability of Black Swan events, the RBI may like to encourage lenders to create good buffers of dynamic (or floating) provisions to strengthen their balance sheets.
The RBI is also considering the introduction of a framework for the securitisation of stressed assets similar to that of standard assets, which will widen the investor base for direct purchases of stressed loans from banks and could lead to better price discovery for banks.
To conclude, the September 30 monetary policy is ‘optimal’, and presents a good balancing act between the pressures of the external world and the domestic growth priorities.
Rupa Rege Nitsure is Group Chief Economist, L&T Financial Services. Views are personal, and do not represent the stand of this publication.
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