Status quo in midst of looming uncertainties in domestic sector

The Reserve Bank of India (RBI) has kept the monetary policy action intact in tune with the market expectations, but assured an accommodative stance as macro-economic fundamentals and external sector unveils more stability.

Every monetary policy review marks a possible turning point for market players despite high predictability and markets known to discount it well prior to the event. The current monetary policy review on Tuesday (June 7) is no exception.

But as a policy, the RBI has been building a robust ecosystem for institutionalising speedy transmission of interest rates in banks to spur growth. Banks have so far passed on about 75-90 basis points (one per cent is equal to 100 basis points) as against reduction of repo rates by 150 basis points since January 2015 leaving lot of scope for transmission.

Introduction of Marginal Cost of funds based Lending Rate (MCLR) system to compute lending rate has brought down interest rates in short tenor but banks may be constrained due to loading of spreads that are allowed to meet their funding costs.

Therefore, the RBI is simultaneously moving to ease liquidity challenges of banks by progressively lowering liquidity deficit from one per cent of Net Demand and Time Liabilities (NDTL) of banks to a position close to neutrality.

This will reduce the cost of funding liquidity mismatches making more room for banks to pass on interest rate cuts. The RBI has, therefore, assured to review implementation of MCLR that can further soften interest rates within the room available with banks even now. Thus the scope for reduction of interest rates in banks will be further harnessed while waiting for more conducive environment to cut repo rates.

RBI has well balanced its stance on tackling emerging challenges in domestic/global economic environment to ring fence against adverse volatility.

Though domestic conditions for growth has started showing early signs of recovery with 7.9 per cent GDP growth recorded in Q4 of FY16, the RBI is waiting for more robust signals for exploring further rate cuts in future.

The forward outlook of RBI ostensibly is to continue to focus on keeping inflation within the policy band which has begun to cause concern.

Retail inflation measured by Consumer Price Index (CPI) has moved up from 4.83 per cent in March 2016 to 5.39 per cent in April 2016 with an added concern that Whole Sale Price Index (WPI) has for the first time moved into positive band recording 0.34 per cent rise in April 2016 as against -0.85 per cent in March 2016.

Inflation is further likely to edge up to 5.52 per cent in May due to delay in monsoon and spike in food prices. Such unexpected spurt in inflation indexes are exacerbating fears of hurting growth prospects.

As a consequence, inflation now stands at 52 basis points above the target of 5 per cent to be reached by January 2017, if May inflation is considered. Moreover, the implications of 7th pay commission may push up prices further threatening the inflation glide path. However, the well distributed South West monsoon expected now should be able to improve outlook for agriculture.

In the midst of uncertainties looming in domestic sector, the implications of evolving external sector and geopolitical events cannot be ignored in policy perspectives while operating in a globalising economy.

The Global growth is uneven. The crude oil prices having breached the US $ 50 mark (now at US $ 51.33 on June 9) can pose a challenge on fiscal prudence of the government due to increase in subsidy.

With possible monetary policy action by Federal Reserve on the slow growth in Q1 in 2016, US $ can further gain strength with its possible implications on global flows and interest rate dynamics.

The Yen and Euro are strong due to their ultra accommodative monetary policies and spurt in consumer spending and recovering employment and business conditions. With China cooling down, India is standing tall as one of the fast growing economies despite the challenges.

With such global uncertainties and incipient domestic economic revival, the biggest is upsurge in inflation that needs to be curbed with tactful supply side reinforcements.

While good monsoon could provide the much needed relief, banks have to come out of asset quality woes to revive credit off take to aid economic revival.

The year-on-year (YoY) growth of both bank deposits and advances are still languishing in single digit at 9.8 per cent. Among the banks, the state owned banks having larger penetration and market share (over 70 per cent) are unable to focus on lending due to disproportionate pile of bad debts.

While all stake holders (importantly RBI and Government) are collectively addressing the asset quality issues with blend of policy support and institutional level action, banks will have to focus back on lending to various sectors of the economy.

In a bank led economy, the flow of credit is critical to push growth till such time that alternate funding mechanism sufficiently grows. Enlargement of banking space with new set of banks may take time to actively contribute.

While diminishing interest rate curve is linked to a combination of factors that may take time to manifest, the more important critical function is to organise enough credit flow at the going rates to ensure sustained growth of the economy.

Major building block of entrepreneurs who form part of employment intensive economic activity are not that sensitive to interest rates so long as efficient, hassle free and timely credit is made available.

Hence, in real sense, the current ‘status quo’ in interest rates is most appropriate in the given economic environment and need not necessarily douse the growth sentiments so long as sufficient credit is made available to the grass root level.

RBI is precisely doing that with enough liquidity support that can, going forward enable banks to (i) reduce interest rates and (ii) ensure flow of seamless credit.
(The author teaches at the National Institute of Bank Management NIBM, Pune. The views are his own)

By Dr K Srinivasa Rao