RBI constrained by surplus liquidity, weak monetary policy transmission

As the inflation projections suggest, with the upside risks being larger than downside risks, one could see the interest rate cycle going up


To maintain liquidity neutrality, various measures such as variable rate repo operations, open market operations, issuing cash management bills and market stabilisation bonds were indicated in the report. Photo: Aniruddha Chowdhury/Mint
To maintain liquidity neutrality, various measures such as variable rate repo operations, open market operations, issuing cash management bills and market stabilisation bonds were indicated in the report. Photo: Aniruddha Chowdhury/Mint

The monetary policy committee has maintained status quo on the policy interest rate—the repo rate, at which the Reserve Bank of India (RBI) infuses liquidity into the banking system. On the contrary, it has actually hiked the reverse repo rate, at which it drains excess liquidity from the system, to 6%, thus narrowing the policy rate corridor to 25 basis points from the existing 50 basis points. One basis point is one-hundredth of a percentage point.

Further, to maintain liquidity neutrality, various measures such as variable rate repo operations, open market operations, issuing cash management bills and market stabilisation bonds were indicated.

Here, the objective appears to be normalizing the liquidity position so that the operating target of the monetary policy is consistent with the repo rate and at the same time ensure necessary resources to the productive sectors of the economy.

The Monetary Policy Report (MPR), which presents a detailed and well-researched discussion with regard to trends and outlook of the economy as well as risks that it faces from both domestic and external developments, suggests that while growth is expected to revive to 7.4% there are some upside risks on inflation as well. RBI’s baseline projection suggests that inflation by the end of 2017-18 could increase to be close to 5% (compared to 3.6% in 2016-17). This is despite assuming lower world oil price of $50 per barrel (against $54 in the Brent futures market) as well as normal monsoons.

The message that we get from the policy is while RBI could have been more accommodative, it appears to be seriously constrained by two issues: the surplus liquidity in the banking sector and the weak monetary policy transmission.

The surplus liquidity issue is mainly due to the remonetization effect that seems to have brought in uncertainty in forecasts as well as disturbing the overall functioning of monetary policy framework.

On the other hand, the weak policy transmission seems to have made RBI hesitant in using interest rates as a policy tool. This is visible when the MPR discusses the issue of small savings rates where they have a wide spread of between 66 to 95 basis points compared to the average yield on government security.

One interesting finding that the report highlights is that banks increase the risk premium on performing assets to compensate for non-performing assets (NPA) losses. This also limits the transmission to some extent.

Where does the RBI go from here?

The space for further reduction in the interest rates, at least in 2017-18, is rather limited. Rather, as the inflation projections suggest, with the upside risks being larger than downside risks, one could see the interest rate cycle going up.

This leaves the revival of growth entirely to fiscal policy, along with some favourable global conditions. But much more action may be needed in resolving banks’ stressed assets that are constraining the transmission and credit flow. Until we overcome the issue of stressed assets, we may overlook the interest rate channel.

N.R. Bhanumurthy is a professor at the National Institute of Public Finance and Policy.

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