Rating RBI's Policy: Beyond Rate Cuts

The Global ANALYST, March 2019

Rating RBI’s Policy

Beyond Rate Cuts

M G Warrier*

The myth that MPC has two teams representing GOI and RBI has also been broken this time, as a ‘GOI nominee’ and one RBI Deputy Governor on the Committee did not go with the majority decision to cut rates. The MPC’s vote to shift the monetary policy stance from calibrated tightening to neutral was, however, unanimous.

Reserve Bank of India, supported by  a majority decision (4-2) of the Monetary Policy Committee (MPC), on February 7, 2019, decided to reduce the Repo rate by 25 basis points, down from 6.5 percent to 6.25 percent. Mainstream financial dailies next day hailed the decision with headlines like, “RBI Cuts Repo 25 bps, Softer Rate Regime on the Horizon” calling it a big surprise. The Repo rate which was at 8 percent in January 2014 had been gradually brought down to 6 percent in August 2017 and had been raised to 6.25 percent in June and 6.5 percent in August 2018.
The 25 basis point reduction in Repo Rate works out to just 4 percent reduction in the rate. Banking system is at present availing a negligible percentage of their total resources needs from RBI. This explains the poor impact of changes in base rates on lending/deposit rates.
The intention is not to underestimate the good work being done by the MPC since it has started working with statutory backing and holds bi-monthly three days meetings before giving shape to the policy stance each time. The purpose is to highlight the relevance of the process and content of MPC deliberations which penetrate into the entire structure of    Indian Economy, much beyond the decision on base rates.
The myth that MPC has two teams representing GOI and RBI has also been broken this time, as a ‘GOI nominee’ and one RBI Deputy Governor on the Committee did not go with the majority decision to cut rates. The MPC’s vote to shift the monetary policy stance from calibrated tightening to neutral was, however, unanimous.
The announcement says:
“The decision to change the monetary policy stance was unanimous. As regards the reduction in the policy repo rate, Dr. Ravindra H. Dholakia, Dr. Pami Dua, Dr. Michael Debabrata Patra and Shri Shaktikanta Das voted in favour of the decision. Dr. Chetan Ghate and Dr. Viral V. Acharya voted to keep the policy rate unchanged. The MPC reiterates its commitment to achieving the medium-term target for headline inflation of 4 per cent on a durable basis.”
Taking into account fiscal risk, demand pressures, high core inflation and uncertain oil prices, MPC could have kept rates on hold while changing stance. Where was the hurry for the MPC to announce to the world that there is a policy 'U' turn, with the exit of Urjit Patel? Let us wait for the minutes of the MPC meeting which will be published after a fortnight from February 7, 2019. Dr Chetan Ghate and Dr Viral Acharya may have some points to make.  
Usually, the post-Monetary Policy Review debates hover around the repo rate and inflation. All stakeholders have started thinking about the relevance of RBI in taking forward economic reforms and the need to ensure that the central bank stays on in one piece to be available to defend monetary and fiscal policies which get hijacked for extraneous considerations. It is in this context one observes with comfort the present change in the approach of media and analysts to take cognizance of the multiple ingredients of the Bi-monthly policy review exercise RBI has been doing ritualistically as part of its mandated responsibility.  Perhaps, this change to go into small print is one of the welcome byproducts of the forced exit of Urjit Patel. Another outcome is the recognition that public spar over differences in policy perception or veiled threats to invoke provisions like those in Section 7 of the RBI Act which are there for different purposes, to discipline RBI Governor do not serve any useful purpose. It has to be said to the credit of GOI at the highest level, that, rising to the occasion, the crisis arising from the abrupt disappearance of Urjit Patel was resolved within 24 hours by appointing an equally competent person Shri Shaktikanta Das, who didn’t need much familiarization about the ‘functions and working’ of India’s central bank, to take RBI forward from where Patel had left.
State Bank of India chairman Rajnish Kumar profusely praised the February 7 monetary policy statement describing it as ‘rich in content and pronounced in communication’. In reality, the description would go well with at least the preceding four bi-monthly announcements. The problem was, many ignored the real content of the policy announcement read with the statements on regulatory and supervisory policy measures (which are now being simultaneously released with monetary policy announcements) and concentrated on the changes in base rates.
Rajnish Kumar, writing in Mint made the following observations which are indicative of the deeper interest the stakeholders have started showing in the direction the RBI’s policy is moving:
“The policy guidance is also guided by the fact that the global growth outlook has become more uncertain. Among key advanced nations, economic activity in the US lost some steam while in the Euro area, economic activity has lost momentum on weak industrial activity. Commodity prices, including base metal prices, are showing mixed trends. The internal growth signals are also indicating minor moderation in services. Thus, policy accommodation at this juncture was warranted to balance both internal and external growth sources. The fiscal measures provided in the interim budget have bolstered the growth outlook for FY20 at 7.4%. The rate cut of 25 basis points will support the overall growth trajectory, both through investments and private consumption.
This policy should perhaps be appreciated more for its development and regulatory proposals, since such steps could trigger a paradigm shift in the financial markets in terms of new understanding and thinking among market participants.”
RBI’s conscious efforts to be more transparent in communication was evident in the press briefing Team RBI had immediately after policy announcement (see Box) and the online media interaction on the same day.
Opening remarks by RBI Governor Shaktikanta Das at the press briefing that followed the Monetary Policy Announcement on February 07, 2019:
Over the past two and a half days i.e., during February 5,6 and 7, 2019 the Monetary Policy Committee (MPC) reviewed the macroeconomic and financial conditions and prospects and voted by a 4/2 majority to reduce the policy repo rate by 25 basis points. The MPC also voted unanimously to shift the monetary policy stance from calibrated tightening to neutral. I would like to take this opportunity to thank the MPC members for their extremely valuable contributions, and the richness and high quality of the discussions that we had. I also would like to thank our teams in the Reserve Bank who provided inputs and support at various stages of policy formulation.

Let me begin by setting out key developments that the MPC considered while arriving at the policy decision. The MPC noted that global growth is slowing down across key advanced economies (AEs) and in some major emerging market economies (EMEs) as well. World trade is also losing momentum. While international commodity prices, especially of crude, have recovered from their December lows, they remain soft. In consonance, inflation has edged down in major AEs and many EMEs. Global financial markets have regained poise from heightened turbulence in December, with equity markets paring earlier losses, bond yields easing and EME currencies appreciating, aided by a weaker US dollar.

As regards domestic macroeconomic developments, the MPC noted that the CSO has placed India’s real GDP growth at 7.2 per cent in 2018-19, with gross fixed capital formation (GFCF) accelerating, but consumption expenditure moderating and net exports improving. More recent high frequency indicators point to investment demand losing some pace in the third quarter of 2018-19, while credit flows to industry remain muted.

On the supply side, output from agriculture and allied activities and services is expected by the CSO to decelerate in 2018-19. Rabi sowing up to February 1, 2019 has been lower than in the previous year, but it could catch up in the remaining part of the sowing season. The extended period of cold weather in this year’s winter is also likely to boost wheat yields. In the industrial sector, activity measured by the index of industrial production (IIP) slowed down in November, even as capacity utilisation in the manufacturing sector increased above trend. Survey-based indicators point to weakening of demand conditions in the manufacturing sector. High-frequency indicators of the services sector suggest some moderation in the pace of activity.

In its assessment of inflation developments, the MPC noted that headline CPI inflation declined to 2.2 per cent in December, the lowest print in the last eighteen months. Continuing deflation in food items, a sharp fall in fuel inflation and some edging down of inflation, excluding food and fuel, contributed to the decline in headline inflation. Moreover, inflation expectations of households have softened by 80 basis points for the three-months’ ahead horizon and by 130 basis points for the twelve-month horizon. Producers assess that inflation in prices of farm inputs and industrial raw materials eased in Q3 while growth in rural wages moderated.

On the external front, export growth was almost flat while import growth slowed in November and turned negative in December 2018. Consequently, the merchandise trade deficit for April-December 2018 was a shade higher than its level a year ago, although higher services exports and low oil prices should have a salutary impact on the current account deficit in Q3. On the financing side, net FDI inflows to India during April-November 2018 were higher than a year ago. Foreign portfolio flows turned negative in January 2019, after rebounding in November and December 2018. India’s foreign exchange reserves were at US$ 400.2 billion on February 1, 2019.

Turning to the outlook, the MPC took into consideration these developments and revised the path of CPI inflation downwards to 2.8 per cent in Q4:2018-19, 3.2-3.4 per cent in H1:2019-20 and 3.9 per cent in Q3:2019-20, with risks broadly balanced around the central trajectory. GDP growth for 2019-20 is projected at 7.4 per cent – in the range of 7.2-7.4 per cent in H1, and 7.5 per cent in Q3 – with risks evenly balanced.

It is noteworthy that the path of inflation has moved downwards significantly, and over the period of the next one year, headline inflation is expected to remain contained below or at its target of 4 per cent. This has opened up space for policy action. Meanwhile investment activity is recovering but supported mainly by public spending on infrastructure. The need is to strengthen private investment activity. Private consumption also needs to be buttressed. While bank credit flows have picked up and overall flows to the commercial sector have also picked up, they are yet to become broad-based. The favourable macroeconomic configuration that is evolving underscores the need to act now when it is most opportune. In pursuance of the provisions of the RBI Act as amended in 2016, it is vital to act decisively and in a timely manner to address the objective of growth once the objective of price stability as defined in the Act is achieved. The shift in the stance of monetary policy from calibrated tightening to neutral also provides flexibility and the room to address challenges to sustained growth of the Indian economy over the coming months, as long as the inflation outlook remains benign. The decisions of the MPC in this regard will be data driven and in consonance with the primary objective of monetary policy to maintain price stability while keeping in mind the objective of growth.

Now let me turn to some developmental and regulatory policies that have been announced, which complement the monetary policy stance and action. Several measures are being proposed in areas spanning financial markets, regulation of banks and non-banking financial companies (NBFCs), regulation of payment and settlement systems and financial inclusion in the Statement on Developmental and Regulatory Polices, i.e., Part B of the Monetary Policy Statement. These policy actions will be anchored by the goal of financial stability, so that the soundness and efficiency of the financial system in intermediating the economy’s needs of financial resources for productive purposes is preserved at all costs. With regard to financial markets,

i. the Reserve Bank proposes to modify the foreign exchange derivative regulations, i.e., Regulation FEMA-25, in order to improve access and participation by promoting operational ease and removing regulatory differentiation based on residence, product and type of transaction;

ii. a task force on offshore rupee markets will assess the causes underlying the growth of this market and recommend measures to encourage non-residents to access the domestic market;

iii. interest rate derivative directions would be rationalised with the objective of simplifying regulations and reducing prescriptive stipulations to promote liquidity by encouraging participation, product innovation and by easing access norms;

iv. a draft regulation of financial benchmarks is proposed, which is based on the practices recommended by international standard setting bodies and lays down governance, quality and accountability standards for administrators of ‘significant’ benchmarks in the markets regulated by the Reserve Bank;

v. the provision that no foreign portfolio investor (FPI) shall have exposure of more than 20 per cent of its corporate bond portfolio to a single corporate is being withdrawn to encourage a wider spectrum of investors to access the Indian debt market; and

vi. resolution applicants under IBC will be permitted to avail external commercial borrowings under the approval route to lower their cost of funding for repaying outstanding rupee loans availed by the companies undergoing the Corporate Insolvency Resolution Process(CIRP) – this is expected to improve the overall effectiveness of this process.

Proposals relating to regulation of banks and NBFCs include

i. revising the definition of ‘bulk deposit’’ as a single rupee deposit of ‘
2 crore and above’ instead of the earlier threshold of ‘1 crore and above’ in order to provide greater operational flexibility to banks in raising such deposits;

ii. establishment of an Umbrella Organisation for urban co-operative banks (UCBs) that can provide several services so as to enhance public confidence in the UCB sector, provide regulatory comfort and promote financial stability in an inter-connected financial system;

iii. harmonisation of three separate categories of NBFCs viz., Asset Finance Companies, Loan Companies and Investment Companies (which together constitute almost 99 per cent of NBFCs in terms of numbers) by creating a merged category called NBFC - Investment and Credit Company (NBFC-ICC), in order to address the complexities associated with multiple categories of NBFCs and to provide the NBFCs greater flexibility in their operations which would result in diversified product offerings, and better access to NBFI services;

iv. alignment of risk weights of bank exposures to all categories of NBFCs, other than CICs, with their credit ratings, with a view to facilitating credit flow to better rated NBFCs, lowering the cost of bank borrowings for NBFCs and in turn, for end consumers, particularly borrowers of MFIs.

Proposals related to enhancing financial inclusion include two points:

i. Enhancing the limit of collateral free agriculture loans from
1 lakh to 1.6 lakh, keeping in view the overall increase in inflation and rise in agriculture input costs – this is expected to enhance coverage of farmers in getting access to formal credit;

ii. Setting up of an internal working group to examine and recommend measures to address issues pertaining to the policy framework and delivery of agricultural credit in the country.

On the payment systems, the feasibility of bringing payment related activities of Payment Gateway Service Providers and Payment Aggregators under the direct regulatory ambit of the Reserve Bank will be examined. This is considered necessary given their increasing importance in the evolving structure of payment systems in the country and the fact that at present, they are essentially regulated indirectly through the banks with whom they have a tie-up.
Plea to retain the institutional strength of RBI
It is significant to observe that former RBI Deputy Governor Usha Thorat speaking at Stella Maris College for Women recently, covered the evolution of RBI as a ‘full service central bank’ making the institution different from other central banks in the world which carry out mostly core central banking functions. She had this to say about central bank’s policy  and financial independence:
“With regard to goal independence, the preamble to the RBI Act was amended in 2016 to give statutory status to the Monetary Policy Committee (MPC), and to mandate inflation targeting as the primary objective of India’s monetary policy framework. This move implemented the recommendations of the various committees mentioned earlier and has been widely welcomed as a major monetary policy reform. The Act says that the Central Government shall, in consultation with the Bank, determine the inflation target in terms of the Consumer Price Index, once in every five years. This gives the Reserve Bank of India operational independence while the goal is set by the elected government. Recognizing the difficulties involved in narrow inflation targeting for India, the actual range of 2-6% for CPI inflation set in the March 2015 agreement is quite wide and allows for flexibility. The main advantage with having an explicit target is that it sets inflationary expectations, which itself is a factor affecting inflation. Accountability is enshrined in the Act, as there will need to be a report in the case of not adhering to the target.
From the point of financial independence, the Fiscal Responsibility Act that prohibits RBI participation in the primary market is critical in ensuring that there is no fiscal dominance. In the case of the public debt management, there can be no independence and there has always been close coordination between the RBI and the MOF. Another aspect of financial independence is in terms of the transfer of profits to the Government each year. For several years RBI built up internal reserves to ensure that these are commensurate with the growth in the balance sheet. In the recent period, all surplus profits have been transferred on grounds that the capital is adequate based on a risk management model adopted by the RBI. This has led to a reduction in the ratio of the contingency reserve to the total assets of RBI. This is the cushion available to RBI in its balance sheet to ensure flexibility in policy making.”
It cannot be just coincidence  that former RBI governor Dr Y V Reddy chose the subject “Central Banking in India: Retrospect and Prospects” for his ‘Kale Memorial lecture 2018 delivered at Gokhale Institute of Politics and Economics Pune  on February 8,  2019. In a fairly long speech, Dr Reddy has given a recap of the history of central banking in the Indian context and traced the evolution of RBI to its present status. Referring to the present MPC dispensation, he said:
“The monetary policy framework in India has to be operated by the Reserve Bank of India, and the regime is described as flexible inflation targetting. The central government under the new framework determines the inflation target in terms of consumer price index once in five years. It appoints a Monetary Policy Committee consisting of three members including the Governor from the RBI, and three outside experts nominated by the government through a procedure prescribed under the law”.
Dr Reddy’s observations on current challenges faced by RBI needs immediate attention of GOI and RBI. I quote a portion specifically relevant to the strength of RBI, from the speech:
“Current Issues – 2019:
In October 2018, it transpired that Government had sought the opinions of the Governor under Section 7 in order to give directions to the RBI in public interest. This is unprecedented and virtually meant that the channels of normal communication for reaching agreed position between Government and Governor RBI had broken down. The Board of RBI appeared to have differences with Governor on the same issues. These differences came into public domain after a speech by a Deputy Governor.
The Central Bank's Deputy Governor, Viral Acharya gave a landmark speech in October 2018, in which he virtually warned the Government that undermining RBI's independence would attract the wrath of the markets. The speech provoked strong response from the government which interpreted the Deputy Governor's speech – a speech that was admittedly authorised by the Governor, and represents institutional position, as an act of defiance rather than as an expression of disagreement with the Government. It triggered a prolonged war of words between the Deputy Governor RBI and Secretary Economic Affairs, Ministry of Finance, but this subsided with the departure of Urjit Patel in December. The resolution of issues originally flagged for consideration under Section 7 are likely to impact the future role of RBI as evident from debates nationwide on autonomy of Reserve Bank of India. It is interesting that the market reactions to the proposals of RBI have not been as severe or as depressing as it was made out in Acharya's speech presumably because both financial market and Governments have a short term bias. 
First and foremost contentious issue relates to the use of excess reserves in the balance sheet of RBI. This is not the first attempt by the Government in this regard. In 1986, Government demanded RBI's profits in the Government's quest for fiscal relief. Governor Malhotra explained how the profits of RBI were different from the normal profits of other public sector companies, and added that they were notional. He explained that higher transfers would impact the economy adversely and made it clear that the profits of RBI should not be considered as an avenue for augmenting the resources of the Government.
During the reform period till 2013, the Government took several steps to strengthen the balance sheet of Reserve Bank of India and added to the reserves. For instance, the excessive cost of sterilisation which normally is borne by the Central bank was shared by the Government to keep the Central bank strong to be able to serve the Government better in times of difficulties. In recent years, the Government has reviewed this approach. Further, by taking recourse to unprecedented practice of interim dividend, the spirit of limit on Ways and Means arrangement under fiscal management legislation has been compromised. The immediate fiscal needs seem to take  precedence over a renewed assessment of the capital needs of RBI.  
In 2018 the Government took the stand that the existing levels of reserves are in excess of the requirement and, therefore, the excess of reserves could be legitimately claimed for use by the Government. Government was laying claim to stock and not merely flow. In its calculation, the government took into account the revaluation gains on forex assets on account of depreciation of the rupee over the years. RBI, on the other hand, took the view that the reserves are not in excess and that, even if they were in excess, the purpose will be served over the years by sticking to the legal requirement of transferring to its reserves a portion of the current surplus of income over expenditure till the reserves need to be augmented. The Chief Economic Adviser had already proposed that the excess of reserves should be made available for injecting capital to the public sector banks which are currently under-capitalised.  
The law and the current practice are for the Board to determine on a yearly basis the excess of income over expenditure, the amount required for addition to its reserves and then the residual is transferred to the Government as dividends. This surplus thus flows to the Consolidated Fund of India for use as it deems fit. As part of the reforms, a formula was approved by the Board for transfer of such reserves and remained in force till 2014. However, the Government took the position that the level of reserves of RBI are in excess of needs and that the entire surplus of income over expenditure should be transferred to the Government. This was done in the year 2015.
There is no doubt that in the ultimate analysis, the Government as the owner has a claim over the reserves, but the way it exercises gives signals to the market  and influences public opinion. In law, the Board will have to decide on this, and the Board members are nominated by the government. There are two substantive issues. One is determination of excess reserves and whether this should only be confined to realised gains or can apply to revaluation gains as well, and the second issue is the immediate use of excess reserves, as determined.
There are different approaches to the level of capital of a central bank. One view is that Government will provide support to it when needed and hence issue of adequacy does not arise. All income over expenditure every year could get transferred to Government. Alternatively the government may like to assure the markets that its Central bank has the Capital to meet contingencies that may arise without depending on governments. There is merit in keeping at least central bank's balance sheet strong if the Government's fiscal balance sheet is weak. But substantively, it is the judgement of Government that prevails on the adequacy issues though procedurally that of Board.
Use of reserves accumulated in the past will have to consider three factors, namely, a) the macroeconomic implications of such transfers, in particular, the monetary implications which are likely to be expansive; b) the issues of inter generational equity since the reserves have been accumulated as an Insurance for the future; c) the constitutional propriety of using the reserves directly to fund capital of the banks instead of crediting it to Consolidated Fund of India and then using it as considered necessary by the Government, and d) the incongruity of the banking regulator being asked to use its resources to fund banks that are in need of the  capital. A Committee has been appointed to advise the RBI on the capital framework and related matters.”   
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*My books:
Economy, finance and social sectors
India's Decade of Reforms, 2018
Chasing Inclusive Growth, eBook, 2018

Personal Finance
Saving for Survival, 2018

Media Response
Assorted Letters of Dissent, 2018


Ants and Honeybees
Unscrambled Monologues


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