The Reserve Bank of India (RBI) delivered a near perfect policy cartwheel, much like US Federal Reserve chairman Jerome Powell did two weeks back. From a hawkish October policy when it changed its stance from neutral to “calibrated tightening”, the Indian central bank today glided back to a “near-neutral” policy with the ease of a trapeze artiste.
In the din of the change in policy stance, we must not miss the seminal change in its inflation estimates: the earlier inflation estimate was 3.9-4.5 percent for the second half of the current year. That has been cut by a full 120 basis points. Likewise for the first half of FY20, the central bank has brought down its inflation estimates from 4.8 percent earlier to 3.8-4.2 percent, which is again a cut of nearly 100 basis points.
One basis point is a hundredth of a percentage point.
Basically, RBI governor Urjit Patel is telling us that inflation shall remain under or at 4 percent for practically the entire next 12 months. Then, is there any necessity to keep interest rates over 250 basis points above the inflation rate?
The governor has all but agreed that he will cut if there are no upside inflation shocks. Sample this: “If the upside risks (of crude and fiscal excesses) do not materialise or are muted in their impact on the incoming data, there is a possibility of space opening up for commensurate policy actions by the Monetary Policy Committee (MPC).”
That’s the biggest take-away. Not only has the MPC delivered on its monetary policy goal of 4 percent consumer price index (CPI), it also stands ready to cut rates if its US counterpart signals an end to its tightening cycle. The markets were quick to react. The yield on the 10 year bond crashed below 7.5 percent to 7.44 percent.
The Deputy Governor Does A Draghi
Second, if governor Patel did a Jerome Powell, his deputy governor (DG) Viral Acharya did a Mario Draghi. The DG all but promised that RBI will do “whatever it takes” to restore normalcy in the non-banking financial companies (NBFC) sector. In his own words, “Measures undertaken by RBI has eased stress in the NBFC sector. RBI is ready to be lender of last resort provided conditions warrant such an extreme measure; but we see no such necessity at the current moment”.
The fixed income sector was all smiles. Two fund managers told CNBC-TV18 that corporates are already returning to the liquid and fixed income funds and with the assurance on dovishness and stand-by support for NBFCs, the commercial paper (CP) market could limp back to normalcy in one quarter rather than two. The CP yields of most maturities even for NBFCs fell by about 5 basis points. V Rangan, executive director, HDFC, was quick to point out that the 9 percent, 10 year bond that his company raised last week is now trading at 8.75 percent.
The third big announcement was a promise that open market purchases will likely continue at the current pace of Rs 40,000 crore a month from January to March as well. In the DG’s words, “Based on our assessment of durable liquidity needs going forward, we have already announced an OMO (Open Market Operations) purchase program of Rs 40,000 crore for this month of December. We expect that this increased frequency and quantum of OMO purchases may be required until end of March.”
This effectively means the RBI will be buying about Rs 2.7 lakh crore of government bonds in FY19, i.e. 60 percent of the total net issuance of Rs 4.6 lakh crore budgeted for this year. This step almost smacks of monetisation of the deficit by stealth. To be sure, this has been an unfortunate result of the huge outflow of dollars from the country and the leakage of cash from the banking system, which hasn’t been plugged despite demonetisation. However, for the debt markets, the government and the economy, this liquidity is a huge bonanza.
If the proactive promise of open market bond purchases pampers a cash strapped government, the reduction of statutory liquidity ratio (SLR) can bring some discipline to the fiscal situation in the long term. SLR is the percentage of their deposits that banks must invest in government bonds. At 19.5 percent in India, this amounts to financial repression of the banks. The reduction of SLR to 18 percent was opportunistic and is a long term positive.
Finally, the big plus of this policy is its effort to push improvements in the banking sector. First, the RBI has sought to peg floating rate retail loans to external benchmarks like treasury bills or government bond yields. It’s unlikely this will strengthen the hands of the borrower to bargain for lower rates, but it’s a much needed step to bring some market discipline to the banking system. Hopefully, it will be followed up a rule forcing banks to benchmark deposit rates too to external pegs.
Likewise, the rule that companies must borrow 40 percent of their working capital limits as a clean loan is welcome. It will transfer the risk of cash management from the banks to the borrowers, where it should lie.
Thirdly, the RBI is all set to allow non-residents to participate in the interest rate derivatives market. If implemented without too many limits, this step can bring huge liquidity to the interest rate derivatives market and make it easy for domestic banks and companies to hedge their risk. This is a revolutionary move, but one needs to wait for the details.That the RBI is persisting with its fundamental task of reforming the banking system and the debt markets even at a time of wildly seesawing macros and a bitter battle with the government, merits appreciation.