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Business News/ Opinion / Online-views/  For RBI, monetary transmission bigger challenge than rate cut

For RBI, monetary transmission bigger challenge than rate cut

After two wasted rate cuts, should the RBI go for yet another?

RBI governor Raghuram Rajan. Photo: Abhijit Bhatlekar/MintPremium
RBI governor Raghuram Rajan. Photo: Abhijit Bhatlekar/Mint

The average consumer price inflation in India in fiscal year 2015-16, according to most analysts, will be in the range of 5.25-5.5%, at least 50 basis points lower than the Reserve Bank of India’s (RBI) 6% target for January 2016. Many, in fact, expect RBI to bring down the target for the year to 5.5%. Since RBI governor Raghuram Rajan has been talking about a 1.5-2% real interest rate, clearly there is scope for a 25-50 basis points reduction in the Indian central bank’s benchmark policy rate from the current level of 7.5%. A basis point is one-hundredth of a percentage point.

The question is: When will we see the next round of rate cut? Will RBI announce it on Tuesday when it unveils its annual monetary policy for 2016, or will it wait till the June bimonthly policy? Of course, it does not necessarily have to wait till June if it decides to maintain the status quo on 7 April as there can always be a rate cut outside the monetary policy. After all, there have been two back-to-back inter-meeting rate cuts in January and March—of 25 basis points each.

While announcing the rate cut on 4 March, Rajan had said that further monetary action would depend on a host of factors, including incoming data, especially on the easing of supply constraints; improved availability of key inputs such as power, land, minerals and infrastructure; continuing progress on high-quality fiscal consolidation; the pass-through of past rate cuts into lending rates; the monsoon outturn and, finally, international developments. Indeed, the government has cleared three important bills in Parliament related to coal mines, insurance and mining, but on most counts there have not been any significant developments on any front in the past one month that could influence RBI. Still, at this juncture, there are equally strong arguments both in favour of and against a rate cut.

Let’s first look at the arguments in favour of a rate cut.

First, consumer inflation in February quickened to 5.37% from 5.19% in January, driven by food inflation, but the so-called core inflation, or non-food, non-oil, manufacturing inflation, remained unchanged at 4.2%, and inflation expectations of households (data for which will be available with RBI ahead of this policy) are probably on a decline. This and subdued economic activity in Asia’s third largest economy certainly create room for the central bank to cut rates.

Second, India’s policy rate at the moment is not in sync with the global rate architecture. At 7.5%, RBI’s repo or repurchase rate stands out in the backdrop of monetary easing in Europe, Japan and China, and the US delaying its plan to hike the policy rate. As a result of this, India, being an island of relatively high interest rates, is attracting foreign funds that, in turn, are putting pressure on the local currency. RBI added close to $40 billion to its foreign exchange reserves in the just-concluded fiscal year, buying dollars from the market even as the rupee continues to be overvalued. An overvalued currency is affecting India’s exports, and weak exports are not good news for Prime Minister Narendra Modi’s Make in India project. A rate cut will ease the pressure on the currency.

Third, and finally, there is no reason to believe that there is no political pressure on Rajan to cut rates. Traditionally, the federal government in India has always been in favour of lower interest rates to fuel economic growth (and containing inflation is the headache of the central bank) and this has not changed even after the Bharatiya Janata Party-led National Democratic Alliance government at the centre entered a historic agreement with RBI for flexible inflation targeting.

Now, two key arguments against a rate cut.

Indeed, the inflation genie is being bottled, but food inflation can play a spoilsport in the backdrop of the unseasonal rains, and waiting and watching for the monsoon to play out will probably be a wiser step than rushing for a rate cut. After all, nothing has changed between 4 March and now. Besides, core inflation seems to have bottomed out and, from now on, it can only rise.

More importantly, the previous two rate cuts—in January and March—have been wasted as banks have refused to lower their lending rates even as many of them have tweaked their deposit rates. What’s the point of having a rate cut that only fuels a rally in government bond prices and the economy does not get any benefit?

The biggest challenge before RBI at this point is not lowering its policy rate, but ensuring monetary transmission. How can this be done?

There have been quite a few suggestions in this regard. For instance, RBI can cut commercial banks’ mandatory bond holding, or the so-called statutory liquidity ratio (SLR), currently pegged at 21.5%. Any cut will theoretically allow banks to use more money to give loans to borrowers instead of investing in government bonds. Similarly, banks’ cash reserve ratio (CRR), or the deposits that commercial banks are required to keep with RBI (on which they do not earn any interest), can also be cut. If it’s brought down to 3.5% from the current level of 4%, at least 43,000 crore will flow into the system. Besides, RBI can also bring down banks’ average daily CRR maintenance to 70% (which they used to do till June 2013) from the current level of 95%.

If RBI is serious about banks passing on the benefit of monetary easing to the borrowers by lowering loan rates, it needs to reorient its monetary policy architecture and shift the focus from interest rates to liquidity as a tool. The Urjit Patel Committee report, based on which the flexible inflation targeting agreement has been signed, spoke about a standing deposit facility that offers the central bank “a window to intervene in both directions, when needed, to achieve the operating interest rate target". Such a facility would have allowed RBI to suck out liquidity from the system at a rate below its repo rate (say, 7%) and this could have been the market rate—50 basis points lower than the repo rate. However, since RBI’s borrowing from banks through this window is not backed by collateral, the RBI Act needs to be amended to create this facility.

There is another way to bring down the market rates and ensure that banks lower their lending rates. Currently, the repo rate, or the benchmark policy rate, is 7.5%. RBI lends to banks at this rate. While borrowing from RBI, banks offer government bonds in their portfolio in excess of SLR requirement as collateral. The reverse repo rate, or the rate at which RBI borrows excess money from banks, is 100 basis points lower, 6.5%. There is another rate called MSF, or marginal standing facility, which is at 8.5%. If a bank needs money but does not have excess government bonds in its portfolio, it can dip into its SLR holding up to 2% and borrow from RBI at a higher rate. Essentially, in a liquidity-deficit scenario, the repo is the operative policy rate, and when there is liquidity in the system, the reverse repo becomes the policy rate.

Till a few years back, the repo and reverse repo rates were both operative rates and they used to create a corridor within which the market rates moved, but in the past few years, RBI has been keeping the system always in a liquidity-deficit mode and thus the repo has become the single operative rate. RBI needs to allow liquidity in the system and let the reverse repo rate come into play. Currently, whenever RBI wants to suck out liquidity, it does so not through the vanilla reverse repo window but reverse repo auctions where the rates are closer to the repo rate. This is because the reverse repo rate is too low. To address this, RBI should hike the reverse repo rate by 50 basis points and narrow the gap between the repo and reverse repo rates (repo rate at 7.5% and reverse repo rate 7%). This will automatically bring down the market rate to 7% and help banks lower their loan rates.

Where will the liquidity come from? Money will be generated through RBI’s dollar buying from the market. For every dollar it buys, an equivalent amount of the rupee flows into the system. India will continue to attract foreign funds in a big way at least till such time that the US Federal Reserve hikes its rate and the central bank will have to buy dollars to rein in the local currency’s runaway appreciation. If it does not sterilize the money (through open market operations, or OMOs, by selling bonds), there will be liquidity in the system, and in a liquidity-surplus banking system, the reverse repo becomes the operative policy rate. Depending on the requirement, it has the flexibility to suck out liquidity and bring back the sanctity of the repo rate.

Instead of keeping the banking system always starved of liquidity, RBI can bring down the market rate through effective liquidity management. This is a better way of forcing banks to pare their loan rates than a cut in CRR, which is more permanent in nature.

Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Financial Services Pvt. Ltd, India’s newest bank in the making. He is also the author of Sahara: The Untold Story and A Bank for the Buck. Email your comments to

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Published: 06 Apr 2015, 12:31 AM IST
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