Context

February signalled a new dynamic-Monetary policy is no longer driven by MPC.

What changed after December MPC review

• Pause in the rate cut by MPC: In its December policy, the Reserve Bank of India suddenly paused on cutting rates, putting the ball in the government’s court to support growth.
• Conservative union budget: With last week’s Union Budget belying expectations of short-term growth boosters, the ball was back in the RBI’s court.
  • The Budget opted for fiscal conservativism over activism, consolidating the fiscal deficit to 3.5 per cent of GDP in 2020-21 from 3.8 per cent in 2019-20– bypassing any ambitious expenditure boost or significant tax cuts.
• Rise in the inflation in Dec-Feb interval: Meanwhile, the policy arithmetic turned more complicated for the MPC.
  • At the time of the December policy meeting, CPI inflation was trending close to 5 per cent (the October reading was 4.6 per cent).
  • Since then a combination of supply-side shocks, which led for example to unseasonally high vegetable and protein prices, buoyed inflation to over 7 per cent, nearly 140 basis points above the RBI’s upper bound comfort zone of 6 per cent.
  • As a primarily inflation-targeting central bank, this effectively stopped the MPC from easing further. 

Key takeaways from February MPC meeting

• The February policy meeting removed two key uncertainties in the current policy scenario.
• First, the RBI is still very concerned about growth and the burgeoning negative gap between the current growth trajectory and potential growth.
• Second, monetary policy is no longer strictly limited to the MPC’s decision-making.
  • Because of the risk of supply-side shocks hitting inflation, it is understandable that the RBI has summarised its outlook on inflation as “highly uncertain”.
  • Hence, of the policy measures that the RBI has at its disposal, the MPC’s “conventional” arrow of rate cuts was left unused.
  • Instead, the RBI has opted for macroprudential intervention, unveiling two other “unconventional” policy arrows.

RBI opting for macroprudential intervention in two ways

• Policy transmission via LTRO-the first arrow: The primary macro challenge has been transmission via the credit channel — banks are not lowering their deposit rates.
  • Why? This is due to competition from the small savings rate and to protect saver, and in turn are keeping lending rates high.
  • How it impacts economy: Sectors considered higher risk (real estate, MSMEs) find themselves credit-starved.
  • In a move that seems inspired by the European Central Bank’s quantitative easing in 2011, the RBI’s announcement on long term repo operations (LTROs) has been aimed at promising banks longer-duration liquidity at the repo rate, which is cheaper relative to their current deposit rates.
  • The aim is to nudge them to kick-start the credit cycle.
  • The exemption of cash reserve ratio for incremental loans to MSMEs and the retail sector is also aimed at lowering costs for banks, which ideally should be passed onto these sectors.
• Managing the stress in financial system-the second arrow: It is aimed at managing the looming stress in the financial system from bad loans, especially as deleveraging becomes more difficult during an economic slowdown.
  • Extension to restructuring durations: The extension of the restructuring scheme on MSME loans and projects in the commercial real estate sector is aimed at releasing capital for banks in the short term.
  • Though banks will ultimately need to recognise loans that are non-performing.
  • Easing guidelines on the classification of loans: Similarly, easing guidelines on the classification of loans for projects in the commercial real estate sector that have been delayed is essentially designed to provide some breathing space to banks.

What does this mean for the macro outlook?

• Recovery in demand is a must: The RBI’s new macroprudential measures, its “unconventional” policy arrows, while well-meaning, are ultimately supply-side measures.
  • For the RBI to attain its goals, be it on asset quality or transmission, there eventually needs to be a recovery in demand conditions.
  • ECB’s LTRO experience: To be fair, even the ECB’s LTRO programme has had mixed success — a central bank can flood the market with liquidity, but the ultimate onus on releasing it to the real economy rests with banks.
  • So far, excess liquidity has not benefitted segments considered high risk (real estate developers, MSMEs).

Conclusion

The ECB introduced the LTRO programme when growth was weak and the euro area was struggling with a severe sovereign debt crisis. With the RBI embarking on something similar, albeit on a smaller scale, the niggling concern is if there is more financial instability lurking around the corner but not yet evident in the current data.

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