Photo: Bloomberg
Photo: Bloomberg

RBI rate cut: QE with Indian characteristics?

The April monetary policy could have a significant bearing on monetary transmission if RBI is successful in achieving its new liquidity objective

The rate action and guidance in the April monetary policy statement was along expected lines, with the Reserve Bank of India (RBI) cutting the repo rate by 25 basis points (bps) and providing a neutral sounding guidance. Along with the repo rate cut, RBI also hiked the reverse repo rate and cut the marginal standing facility rate. The result of this rather confusing set of actions is that the LAF (liquidity adjustment facility) corridor now stands at 100 bps, compared to 200 bps hitherto. More substantively, RBI also announced a revamped liquidity framework to suit the accommodative phase of the monetary cycle. Safe to say that the liquidity announcements packed the real punch compared to the rate announcement.

As far as the rate announcement was concerned, RBI cited inflation outturn and its projected path, fiscal consolidation adopted by the government, structural reforms and weak investment demand as the driving factors. In its guidance, RBI retained the “accommodative stance" phrase and signalled that further action will be data contingent.

Note that the inflation fan chart foresees CPI inflation remaining range bound around 5% through FY17. However, in the accompanying Monetary Policy Report, RBI has cited some clear and present upside risks to its inflation trajectory. Thus the implementation of the Seventh Pay Commission is expected to add 150-190 bps to headline inflation over a period of two years. Assuming the government implements the pay commission in full by the end of this fiscal year, this would imply upside risks to the trajectory in FY18 when the target will be reset to 4%. Accordingly, we see only a slim chance of further rate reduction at this point of time.

RBI’s extant liquidity framework was a mix-and-match between two committee reports—the Deepak Mohanty committee report on operating procedure of monetary policy and the Urjit Patel committee report on monetary policy framework. With the changes announced on Tuesday, RBI is hoping to strengthen and clarify its liquidity stance. In the process, it has given rise to some questions.

Briefly, RBI will now target average system liquidity balance to remain at zero compared to the deficit (indicated at 1% of NDTL) target hitherto. More importantly, RBI will endeavour to provide durable liquidity to meet this target over the next year. The durable liquidity will consist of purchases of both foreign assets and domestic assets. In periods when foreign assets are not being added to, then RBI may have to compensate by buying more domestic assets, i.e. government securities. Assuming that this year the need for durable liquidity is over 2.25 trillion and average system deficit in FY16 was over 700 billion, then RBI will have to add nearly 3 trillion of durable liquidity over 12 months to achieve “neutral" system balance. If RBI is able to add only 1.3 trillion (~$20 bn) of forex assets, this means residual OMO (open market operation) purchases of 1.7 trillion are needed to meet its targeted liquidity objective. This will amount to nearly 40% of the net G-Sec borrowing by the central government. Should forex purchases be lower, i.e. should the rupee come under pressure due to insufficient capital inflows into India, the required OMO purchases will go up. Thus the new liquidity objective could lead to a perverse outcome of a weaker currency leading to more monetary policy accommodation via bond purchases by RBI. Second, by targeting overall liquidity instead of core liquidity (liquidity excluding government balances), RBI has left itself open to the trap of modulating build-up of government surplus with permanent liquidity injection. This shouldn’t be an issue if government surplus is mean reverting but government surplus has trended up over the last year. Third, as the OMO purchase quantum increases, RBI will be in the unenviable position of indirectly funding a larger and larger proportion of the government’s fiscal deficit. This would lead to doubts about the credibility of RBI’s inflation targets should the government slip from its deficit targets.

To sum up, the April monetary policy could have a significant bearing on monetary transmission if RBI is successful in achieving its new liquidity objective. The central bank will be able to do so comfortably if both forex purchases and OMO purchases are kept at an even keel. However, this is not entirely within the central bank’s control as forex purchases are a by-product of currency movements and net inflows. Thus RBI’s new experiment may be yet another (futile) exercise of an emerging market central bank trying to break out of the tyranny of external constraints.

A. Prasanna is chief economist at ICICI Securities Primary Dealership.

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