The Reserve Bank of India (RBI) left the policy rate on hold in line with market expectation during its policy meet on February 2. It maintained inflation projection at 5 per cent by March 2017 despite softening oil prices waiting for clarity after the budget.
It did not change the current year growth estimate of 7.4 per cent year-on-year but lowered the FY 2016-17 growth forecast to 7.6 from 7.8 per cent announced earlier due to weak domestic private investment, increase in stalled investment projects, excess capacity and sluggish external demand.
In its forward guidance, the RBI reiterated its “accommodative” stance. Interestingly, the Central Bank put the ball back in government’s court as it stated, “...Structural reforms in the forthcoming Union Budget that boost growth while controlling spending will create more space for monetary policy to support growth.”
In its interaction with the media, the RBI clarified that it will look at the whole package of reforms in the budget and not just the fiscal deficit number – measures to control spending, incentivise investment and skill-building – thereby nudging the government to remain on the path of reforms so as to create space for one more rate cut after the budget.
However, the RBI did not provide any details on the liquidity framework despite increasing concern regarding the recent tight liquidity conditions in the system that are hampering transmission of rate cuts. Even if the RBI had slashed policy rates by 25 basis points (bps), the lending or borrowing rates would not have budged.
The banking system is grappling with tight liquidity borrowing on average Rs 1.3 lakh crore daily from the RBI for its everyday operation in last couple of months. This has kept 10-year bond yield that acts as a benchmark for interest rate in the economy and signals the change in rate cycle, at elevated levels of 7.7 per cent on average in January 2016, same as last year.
We have been on the easing interest rate cycle since January last year and the Bank has delivered 125 bps of rate cuts since then. The interest rates on commercial papers (CPs) and certificates of deposits (CDs) that are market determined, initially came down in line with policy rates before inching up again since November 2015 due to tight liquidity. Base lending rate of banks came down by only around 60 bps limiting the positive impact of lower interest rates on consumption.
It is well known fact that tight liquidity conditions works best in monetary policy transmission when we are in rate tightening cycle not during the easing cycle like the one we are in now. The Central Bank did start buying bonds in the last couple of months to infuse liquidity but the quantum and frequency remained well below requirement.
With inflation falling substantially, the real interest rate paid by the corporates on their borrowings is at record high. This increased the debt servicing cost of corpora-tes stretching their balance sheet and thereby transferring stress to the banking sector.
The seasonal liquidity tightness in the banking system in December was exacerbated by high cash balance of the government which rose to around Rs 1.4 lakh crore by end of January. It is believed that there is a conscious effort to reduce the government spending to meet the fiscal deficit target even though government denies that. Media reports suggest that the finance ministry is planning ahead to pay for bonds worth Rs 77,000 crore that are maturing in April. This squeeze on spending and hence liquidity, has spiked bond yields and prevented a fall in lending rates.
Bond yields, of course, depend on a confluence of factors including demand-supply dynamics. Demand for the Central government bonds in the secondary market has gone down. The provident fund, one of the large buyers of bonds, is switching to state government bonds due to higher returns. On the other hand, the supply of bonds are expected to remain high next fiscal on higher spending on the Seventh Pay Commission recommendations.
Govt bonds
In addition, about Rs 1 lakh crore of loans to state power utilities or discoms will be converted to bonds which banks will have to accommodate on their treasury books reducing their holdings of Central government bonds. This unfavourable demand-supply dynamics are keeping the pressure on yields.
From the above discussion, it is obvious that it is necessary to bring liquidity deficit in the system to an acceptable level to help soften bond yields and thereby the lending rate, and reduce borrowing cost for consumers and corporates.
The government has already announced a buyback of Rs 20,000 crore of bonds after the policy meet in order to infuse liquidity. This needs to be followed by higher government spending or bond buying by the RBI to ease the liquidity deficit.
Most probably, the Bank kept the liquidity tight to stabilise the rupee against the backdrop of US Fed raising rates in December. However, the rupee has become overvalued against a basket of currencies as other emerging market currencies, including the Chinese Yuan, have weakened recently. India’s real effective exchange rate (REER) is now about 6 per cent above its long-term mean.
At this point, it may not be wise to go against the tide and push for a stronger rupee as that will only hurt our exports which will adversely impact capex addition, and hence employment generation and overall growth. If the RBI continues to defend the rupee by selling dollars, the liquidity deficit will worsen keeping the interest rate high.
Easy liquidity and softer lending rate is essential to boost demand, revive growth, help clean up corporate balance sheet and improve the asset quality of banks. Otherwise, India’s growth trajectory, which is already facing global headwinds, will get bumpy.
(The writer is senior researcher, Centre for Policy Research, New Delhi. Views are personal)