Is The RBI-MPC Wall Blurring The Central Bank’s Vision?

India's Monetary Policy Committee announces its latest review this Thursday, with another interest rate cut widely expected.

Should the panel choose to cut the benchmark repo rate by the anticipated 25 basis points, the total quantum of rate cuts during the course of the calendar year would go up to 160 basis points. The policy rate would stand reduced to 4.9 percent.

For those interested in monetary policy trivia, this would be the first time in a decade that the repo rate is below 5 percent. This is also the first time since the global financial crisis that we have seen such a steep cut in rates in any twelve-month period.

The committee's decision will be guided by stark weakness in the economy. Real gross domestic product growth fell to 4.5 percent in the second quarter of FY19 and nominal GDP growth fell to 6.1 percent. Weakness in demand conditions has pulled down core inflation to about 3.5 percent—the lowest in the current consumer price index series. This, despite the fact that headline CPI inflation moved above the 4 percent mid-point of the MPC's inflation target of 4 (+/-2) percent.

In his very first press conference in February, Reserve Bank of India Governor Shaktikanta Das had said that “the law mandates that we need to look at the headline number, so we have to go by the headline number”. At the time, core inflation was running high, even though headline inflation was below 4 percent.

With the situation now reversed, Das will need to caveat his earlier statement while explaining why the MPC chose to cut rates even as inflation has moved above 4 percent. He can take refuge in the belief that the move-up in food prices is temporary and also cite the MPC's flexible inflation targeting mandate in justifying a sixth consecutive rate cut.

Needless to say, that decision to cut rates again, if taken, would be fully justified in the face of evidence of weakened demand conditions.

Looking Beyond Interest Rates

But the more complex issues that need to be tackled are well beyond the official remit of the MPC.

Few believe that one more rate cut will make a material difference to the economy at this stage. The real problem is that of fund flows, with vast swaths of the economy seeing a decline in availability of funding.

At the time of the last review, the Monetary Policy Report had pointed to the notable drop in flow of funds to the economy. Flow of funds to the commercial sector fell to Rs 0.9 lakh crore between April and September 2019, about 87.6 percent lower than the flow of funds during the same period an year ago, the report showed.

Have things changed since then? Bank lending data, which is showing year-on-year non-food credit growth of less than 8 percent, does not suggest so. Non-bank lenders, anecdotally, continue to complain about a credit squeeze.

At its end, the RBI has pivoted towards an easy liquidity stance but the benefits of that liquidity is skewed towards one set of borrowers. A stark example of that is the fact that Non-banking financial companies and housing finance companies like Bajaj Finance Ltd. and Housing Development Finance Corporation Ltd. are issuing commercial paper at interest rates just above 5 percent, which is close to the sovereign borrowing rate. Meanwhile others like Piramal Capital Ltd. are borrowing a good 400-450 basis points above that at above 9 percent.

The issue of monetary policy transmission has also, at best, been only partially addressed. While short term money market rates and bank deposit rates have come down, the impact on lending rates, particularly to existing borrowers remains minimal.

The minutes of the last few MPC meetings showed little debate on some of these real-world credit flow and credit cost issues beyond cursory mentions.

As Sonal Varma, chief India economist at Nomura put it, ultimately, financial stability, whether or not it is in the inflation targeting document, is important.

“The impact of what is going on in the financial sector, the impact of that on aggregate credit conditions, the differentiation we are currently seeing between the retail and wholesale lending portfolios, all of that has an impact on the kind of growth we will see,” she said in a recent interview with BloombergQuint on the state of the economy. “Purely focusing on headline inflation and therefore what the repo rate reaction should be is really going to blunt the impact of monetary policy,” she added.

Also Read: ‘Triple Balance Sheet' Problem May Pull India GDP Growth Down To 4.9% In 2019-20: Nomura

RBI Action Needed To Complement MPC Action

So the question that ought to be debated by the MPC this time is what can be done to revive the flow of credit and strengthen the financial system.

It has been long suggested that the RBI do an asset quality review or a stress test of top NBFCs and HFCs. The regulator has said it is already monitoring the systemically-important non-bank lenders closely. Why not then go a step further and do a formal review and require these lenders to disclose some of the central bank's findings on aspects like,

1. Any concerns over asset-liability mismatches;
2. True asset quality picture;
3. Any additional need for capital.

Till a few years back, this would have been unthinkable to expect, given the opacity with which the RBI is believed to operate. But remember that the regulator has warmed up to the idea that increased disclosures can act as a disinfectant, as is evident from their decision asking banks to disclose divergence in asset quality.

So why not do a stress test on specific parameters of NBFCs and HFCs and ask them to disclose some of the findings?

If not that, what are the other options? We certainly can't go back to a period of directed credit and quantitative targets. At a time when the economy is weak and corporate defaults remain elevated, using macro-prudential tools and reducing risk weights is also imprudent.

Are there other options on the table to revive credit flow?

Should we adopt a do-nothing approach? Allow market forces to play themselves out? That may prove to be costly (as it already has), prolong India's growth slowdown and lead to a shallow-recovery, which is already feared by many economists.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.