By Rupa Rege Nitsure
A transparent monetary policy has a clearly defined goal like price stability. In the case of India, the RBI came out with a new monetary policy framework in January 2014, anchoring for an inflation (CPI-based) target of 4.0 per cent with a band of plus/ minus 2.0 per cent. It has also proposed to bring the targeted CPI (consumer price index) inflation down to 8.0 per cent by January 2015 and 6.0 per cent by January 2016, before bringing it down to 4.0 per cent in three years. The adoption of such a rule-based framework has made the monetary policy exercise highly transparent for India. In fact, in every bi-monthly policy statement, the RBI tries to show the degree of consistency between the actual inflation trajectory and its anticipated path.
The credibility of policy is attained when the central bank’s actions are consistent with reaching its monetary policy goal. The easing of retail inflation for two consecutive months, the recent fall in global crude prices, the benign outlook on global non-oil commodity prices and the government’s firm commitment to fiscal consolidation had given rise to the wide-ranging expectation of an easing cycle. Some had wrongly interpreted the RBI’s stance in the June policy as “dovish” because it had said that further policy tightening will not be warranted, if the economy stays on a disinflationary course witnessed during May-June, 2014. However, that was a conditional statement and in June as well as in August, the RBI has clearly warned of several upside risks to inflation on account of adjustments in administered prices, deficient monsoon and its impact on food production, possibly higher oil prices stemming from geopolitical concerns and exchange rate movement, and growth in the aggregate demand. In the latest policy review, the central bank appears to be more concerned about achieving the 6.0 per cent inflation target by January 2016 than achieving the 8.0 per cent target by January 2015. And, therefore, it has suggested a heightened state of policy preparedness to contain inflationary risks. According to the RBI, a lot depends on the government’s actions on food management and timely completion of projects that would set the pace for the supply-side response.
Given these uncertainties, the RBI remains worried about the medium-term sustainability of the disinflation process and, hence, it has chosen to keep the policy rates as well as the CRR (cash reserve ratio) unchanged on August 5, 2014.
While “pessimistic” on the inflation front, the RBI appears to be quite confident about the evolving growth trajectory. This confidence stems from the improved performance of exporting industries, ongoing revival of investments, unlocking of stalled projects, government’s commitment to fiscal consolidation and its favourable impact on the private sector’s investment expenditures, stabilisation of global commodity prices, etc. According to the RBI, in the absence of any strongly negative surprise from the exogenous factors, an economic growth of 5.5 per cent can be sustained for India during 2014-15.
The other major move in the latest policy review is a cut in the SLR (statutory liquidity ratio) by 50 basis points (bps, from 22.5 to 22.0 per cent of net demand and time liabilities or NDTL), even if there is no significant pick-up in credit demand and the banking industry continues to hold excess SLR securities. In our opinion, this is not just a move to improve liquidity. Rather, it has to be viewed as a long-term reform measure that would improve the functioning of debt markets. As said by the RBI’s Committee on Comprehensive Financial Services for Small Businesses and Low Income Households headed by Nachiket Mor, the SLR as a prudential tool has outlived its utility for both banks and non-bank financial companies (NBFCs), given the much-enhanced emphasis on capital buffers under the new risk-management framework. A high level of SLR in India compared to other emerging markets has distorted not just the interest rate structure but also its usefulness as a signalling mechanism. Moreover, the gradual reduction in the SLR undertaken by the RBI also reflects its confidence in the government’s ability to improve its finances in line with its revealed commitment. This is a strongly positive signal to bond market participants. Of course, given the large supply of government papers in the current month, the said measure may increase volatility in bonds in the short term. But the reform orientation of this measure, combined with appropriate liquidity management by the RBI through term repos of various maturities, should support the bond market sentiment in the medium term. Moreover, this reduction in SLR would increase the resources with banks to extend credit to the private corporate sector by Rs 40,000 crore, once the credit demand picks up.
The RBI also reduced the ceiling for banks’ total holdings of SLR securities in the held-to-maturity (HTM) category to 24.0 per cent of NDTL from 24.5 per cent of NDTL with effect from August 9, 2014. This step is taken to increase banks’ participation in financial markets. This measure may give an opportunity to banks to reduce their HTM holdings as per the market conditions, going ahead. It also means that banks have reduced facility to park securities in the HTM bucket, which, in turn, would force them to value securities at a regular interval and take a hit in the form of mark-to-market valuation, if there is any adverse movement of the security prices. This would promote more disciplined functioning of the banks’ treasury divisions.
Thus, while the primary focus of the policy is on “price stability”, it has touched some critical areas to improve the functioning of the financial markets and support the liquidity conditions for banks.
Given the RBI’s explicitly expressed concern over the inflation outlook from a medium-term perspective, we do not see much scope for the commencement of the easing cycle during the financial year 2014-15.
The writer is chief economist and general manager, Bank of Baroda