Expect the RBI to stay on hold

A monetary policy response to managing liquidity is not currently warranted

The Monetary Policy committee will face a policy quandary in its meeting next week, requiring a balancing act between growth impulse, inflation targeting, liquidity management and currency stabilisation. Lower-than-expected June quarter growth numbers and subsequent general downgrade of GDP growth expectations for the current fiscal has brought back calls for rate cuts for economic growth.

Rate cuts: Pros and cons

The economic survey also highlighted downside risks to FY18 growth projection of 6.75-7.5 per cent, calling for further monetary easing from the central bank to support growth. In all such recommendations, rate cuts appear to be the key to reviving investment and economic growth in India. Since the reasons for growth stagnation are rooted in excessive leverage, low profitability and lack of demand, interest rate cuts on its own will not be able to kick-start private investment cycle meaningfully. Nonetheless, lower rates do have a role in the current cycle in terms of supporting consumption demand and reducing the financing cost and debt obligation of corporates on the margin.

However, aggressive monetary easing to address balance-sheet problems can backfire by mis-allocating investments, fuelling asset price inflation, creating false hopes of a growth boost, and relaxing the pedal on deeper structural reforms. Rate cuts in this milieu will incentivise moral hazard issues.

Besides, in the current financial backdrop of high valuations in equity and fixed income markets, an appreciating currency and the persistence of a liquidity overhang in the money market, a rate cut can be seen as encouraging risk-taking and potentially amplifying the “bubbly and frothy” conditions. While RBI did opt for a rate cut in August citing reduction in inflation risks, consumer price index-based inflation — the gauge used by the MPC to decide on monetary policy — has continued to rise since then and reached the higher end of the central bank’s two to 3.5 per cent target for the first half of fiscal 2018. With inflation likely bottoming out and expected to hit the upper end of target rate, policy space for rate cut to support growth appears tight.

We thus expect RBI to stay on hold in its policy review meet in October despite the June quarter’s ‘disappointing’ GDP data, though a downward revision of its FY18 growth estimates is plausible. Instead, we expect more focus on resolution of non-performing loans in the banking system to revive credit demand and the investment cycle.

Surplus liquidity

System liquidity has remained in surplus, in contrast to the central bank’s preference for a neutral balance. While currency in circulation since demonetisation has been the main driver of volatility in banking system liquidity, strong portfolio and record FDI inflows have helped.

RBI has stepped up intervention to manage surplus liquidity. After briefly raising the incremental cash reserve ratio to mop up deposits in the wake of demonetisation, the central bank has been mopping up surplus liquidity through its daily liquidity operations. In addition, the RBI has been mopping up durable liquidity through various market tools such as MSS issuance and OMO sales. In fact, the RBI has almost fully utilised the ₹1 trillion limit for MSS issuance and sold bonds worth ₹40,000 crore via OMOs so far this fiscal.

However, a monetary policy response to manage liquidity is not warranted. Given weak policy transmission and sluggish credit growth, the risk of excess liquidity spurring inflationary pressures is low at this point.

Also, the surplus liquidity position is expected to normalise gradually as remonetisation progresses and regulatory caps on foreign debt investments impose a limit on the quantum of inflows. RBI’s strong presence in 3-12 M currency forward markets reinforces expectations that liquidity balance will likely narrow by the time these forwards mature. Till such a point when these incremental steps manage to bring the liquidity to normal, we expect the borrowing costs in the economy to stay subdued. However, given the debt overhang and the banking system’s reluctance to lend , it is not likely to have much of an impact on real economy.

The writer is Economist, RBL Bank

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