The striking feature of the RBI credit policy is that there is consistency in stance, and the noise element has been eliminated. This has been an issue for long until the Urjit Patel Committee made the stance clear on the drivers of monetary policy. The critic’s argument was that there was a tradeoff between inflation and growth and that by keeping rates high in the face of high inflation which is caused by supply side factors, we were irrational in thwarting growth.
But the RBI has made it clear that it is not against growth but believes that growth will not be possible unless inflation is under control and that is why we are targeting inflation. Therefore, a target of 8 percent CPI inflation has been set for January 2015 and 6% for January 2016.
The markets, however, have always been irrational and expected a rate cut, because it always wants one irrespective of the macro conditions. It is actually now a no-brainer that rates will be lowered only when CPI inflation comes down and remains within acceptable levels – whether or not one agrees with the rationale.
The RBI does have real interest rates in mind and as long as inflation is above 8 percent (which is also the repo rate) the intuitive real rate is negative. Therefore, one should not read too much into the choice of words of the policy and attribute adjectives as dovish or hawkish, as inflation targeting appears to the revealed goal.
While it may stimulate intellectual debate, the RBI logic and stance is transparent and simple. The corollary is that if inflation comes down in a sustained manner, then rates will be cut and if inflation moves up, we can be prepared for a rate hike.
As a placatory measure the SLR has been lowered by 50 bps. Will this work? Not really, except at the fringe where individual banks are just about holding on to this ratio, will benefit from this cut. For the system as a whole the SLR holdings are around 26.5%, which means that there is voluntary holding of such paper.
While the RBI has explained that it has done so to afford flexibility to banks to use these resources for lending, one should see why banks are holding on to excess SLR paper.
Today returns on government paper are good at around 8.5-9%. Add to this the quality of such assets which is good. In fact, if we use the ratio of stressed assets (NPA plus restructured) as a proxy for non-performing assets, then the probability of lending going bad could be 10%. Investing in government paper makes imminent sense under these uncertain conditions.
Further, the risk weight used for reckoning capital for investment is negligible and hence this kind of narrow banking is attractive. In case, conditions do look up and the demand for credit improves along with the economic climate and hence quality of assets, then banks can still easily liquidate their excess SLR holdings which is 4% above the pre-policy stipulation of 22.5%.
Is there something different that the RBI could have done? Yes, if the idea was to provide liquidity, the repo window should have been opened up further. Right now banks can take 25 bps of NDTL as recourse through the RBI by pledging SLR paper. Another 75 bps can be through term repos where auctions are held periodically.
If the purpose was to help banks with liquidity, the overnight repo window could have been enlarged. But then, the RBI is not apparently concerned with current liquidity and has hence looked at SLR more as a tool for releasing resources for lending rather than to ease liquidity in the money market – which will work in the very short run.
A miss has also been given to the targeted growth in bank credit, deposits and money supply. This normally comes in an annual policy. It was skipped in June and it was felt that with the budget still to come to gain an idea on the deficit and hence the borrowing programme, the RBI would announce the same this time. The numbers are useful for individual banks to plan their own course. But the stance presumably taken is that such targeting is not required from the RBI and the number would unfold through the market play.
How will the markets behave? It will really be business as usual as there is no reason for any of the demand-supply side forces to be affected significantly by any of these measures and therefore, the course of movements would be driven by the existing and emerging dynamics.
Banks are unlikely to alter rates as their overall cost of funds is unlikely to change and given a cautious outlook on the economy, lending rates will tend to remain unchanged. The GSec market will see some traction as the HTM ratio has been lowered which means more release of securities for trading by banks. But this will not quite alter the GSec yields and the 10-year paper will continue to range between 8.6-8.8% for most of the time.
The focus will evidently be on the next policy, but practically speaking the conundrum will arise only if the two inflation releases for July and August show declining CPI inflation. September end is just the beginning of the harvest and the impact of a sub-normal monsoon on kharif farm output will be witnessed in October and November.
If inflation remains high in July and August, it will be a status quo from RBI, but a decline in inflation and uncertainty with the farm outcome and resulting impact on prices, will be a tough call for Mint Street. We have to wait till then.
The author is chief economist, CARE Ratings. Views are personal.
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