The resolve of the Reserve Bank of India (RBI) in its fight against inflation was severely tested on Tuesday. RBI chose to protect its credibility rather than give in to the pressure to pause. But its hitherto fierce anti-inflation stance was somewhat diminished by its own words.
The talk was dovish, almost apologetic. There was even an implicit promise of a pause in December. In trying to provide too transparent a guidance to the markets, its language became accommodative. If it has promised to be hands-off in December, has RBI banished surprise elements from its armoury?
Given that inflation is still close to double digits, it may have been better to keep a hike option open for December. On the other hand, if RBI is so sure that inflation is on a predictable downward path, then what was the need for the Tuesday hike? The markets gave a thumbs-up on the implicit promise of a pause. Given heightened uncertainty and volatility everywhere, there’s no percentage in being consistent or predictable in monetary policy.
While RBI contemplates a pause, it might be worth remembering that the repo rate even at 8.5% is still 50 basis points lower than what is was three years ago in October 2008. Of course, the growth outlook then was distinctly better, although real interest rates are still negative and favourable to investors.
Speaking of interest rates, the big surprise in Tuesday’s policy was the deregulation of the savings rate. Interest rate deregulation began in India in 1990. But for the past 21 years, most of that deregulation was only on the lending side. For instance, complete freedom to price loans was given in 1994, and complete delinking from the prime lending rate was done in 1999. Last year, that deregulation journey culminated in the base rate system. But interest rate reform remained one-sided since it did not benefit the liability side.
Nearly one-third of all bank funds is raised at a cost of merely 3%, whereas these are loaned out at above 13%. This fat margin had to be compressed and, hence, the reform was overdue. The savings rate deregulation will be disruptive, and bigger incumbents with a larger savings book will suffer. But apart from benefiting depositors, the deregulation will hasten productivity enhancing initiatives.
To further unshackle banks, we also need reform of statutory pre-emption of deposits (the statutory liquidity ratio requirement). If the cost of deposits is going up, banks need greater freedom to deploy those deposits in higher-yielding assets, not be forced to tie them up in government bonds. Hopefully, this reform will not take another 21 years!
As banks seek profitable customers, this policy gave them an additional filter to separate risky borrowers. Banks can now add to their credit risk premium if their customers behave irresponsibly on currency exposure. The discipline of risk management while hedging currencies is much needed, and this RBI measure as indirect pressure on corporates, big and small, is much welcome.
Ajit Ranade is chief economist, Aditya Birla Group.