Monetary Policy: Multiple Objectives, One Policy

Submitted version of aticle published in the September 2019# issue of The Global ANALYST:
#{ Article on PSBs Merger inOctober 2019 issue of The Global ANALYST}

Monetary Policy

Multiple objectives, one policy

M G Warrier
“Gold’s long-term prospect is up, up and up, and the reason why I say hat is money supply is up, up and up. I think you have to be buying at any level, frankly. With the efforts by the central banks to lower interest rates, they’re going to be printing like crazy”
Mark Mobius, Founder, Mobius Capital Partners
(Quoted in Business Standard, August 21, 2019)

After receiving and giving some shocks (Yes, the reference is to S C Garg led reference to Section 7 of RBI Act by finance ministry while communicating with then governor Urjit Patel and the premature exits of Patel and Viral Acharya), it is, seemingly, business as usual at Mint Road. The grace with which RBI handled the situation deserves appreciation. If someone is still in doubt about the relationship between RBI and GOI, at every opportunity available, the new finance minister Nirmala Sitharaman has been trying to clear the air by asserting that the two are and will continue to be on the same page.
After the constitution of Monetary Policy Committee, it has to be said to the credit of Centre that there has been less interventions from political leadership (read finance ministry) in the conduct of monetary policy by the central bank. GOI also ensured that the MPC remained a body of professionals with continuity of incumbents.
RBI has all along been performing multiple roles in monetary policy formulation and supervisory functions, besides management of currency, debt and forex reserves with success within the constraints emanating from growth-related and fiscal policy considerations.
An unconventional rate cut
As decided by the Monetary Policy Committee (MPC) which concluded its three-day meeting on August 7, 2019, RBI announced a repo rate cut by 35 basis points (one basis point is one hundredth of one percent), the highest in the recent past. The focus being on arresting the falling economic growth, RBI simultaneously insisted that banks must pass on the benefits to their customers.
The August 7, 2019 resolution of the MPC said:
On the basis of an assessment of the current and evolving macroeconomic situation, the Monetary Policy Committee (MPC) at its meeting today decided to:
• reduce the policy repo rate under the liquidity adjustment facility (LAF) by 35 basis points (bps) from 5.75 per cent to 5.40 per cent with immediate effect.


Consequently, the reverse repo rate under the LAF stands revised to 5.15 per cent, and the marginal standing facility (MSF) rate and the Bank Rate to 5.65 per cent.
• The MPC also decided to maintain the accommodative stance of monetary policy.
These decisions are in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4 per cent within a band of +/- 2 per cent, while supporting growth.”
The observation made by Governor Shaktikanta Das that “Given the current and evolving inflation and growth scenario at this juncture, it can no longer be a business-as-usual approach. The economy needs a larger push.”, perhaps sums up the central bank’s constraints and concerns (see below governor’s statement included in the minutes of MPC meeting published on August 21, 2019)
Excerpts from the minutes of MPC Meeting held in August 2019
 (Source: RBI Website)
Statement by Shri Shaktikanta Das
68. Economic activity has shown signs of further weakening since the last MPC meeting in June 2019. Several high frequency indicators have either slowed down or contracted in recent months. Headline CPI inflation has evolved broadly along the projected lines; CPI inflation excluding food and fuel continued to soften, while food inflation has edged up. Global economic activity has been losing pace, weighed down by intensifying trade tensions and geo-political uncertainty. GDP numbers for Q2:2019 in respect of some major advanced and emerging market economies have been subdued. Central banks in both advanced and emerging market economies have been increasingly resorting to more accommodative stances of monetary policy.

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69. Headline CPI inflation rose to 3.2 per cent in June 2019 from 3.0 per cent in April-May. Food inflation rose by 100 bps in May-June, driven mainly by a pick-up in prices of meat & fish, pulses and vegetables. On the other hand, CPI inflation excluding food and fuel moderated for the fourth consecutive month to 4.1 per cent in June, caused by a broad-based softening across groups, particularly clothing and footwear; household goods and services; and transport and communication. This reflects subdued input cost pressures relating to both agriculture and industrial raw materials and further weakening of domestic demand conditions. Inflation in the fuel and light group also decelerated in May-June, despite the uptick in liquified petroleum gas (LPG) prices. Inflation expectations of households in the July 2019 round of the Reserve Bank’s survey moderated further by 20 basis points for the 1-year ahead horizon, though they remained unchanged for the 3-month ahead horizon. Cumulatively, inflation expectations of households have declined significantly by 180 basis points for the 3-month horizon and 190 basis points for the 1-year horizon in last five survey rounds. This suggests that inflation expectations of households are gradually getting better anchored. Overall, the inflation situation remains benign. CPI inflation has been projected at 3.1 per cent for Q2:2019-20 and 3.5-3.7 per cent for H2:2019-20, with risks evenly balanced. CPI inflation for Q1:2020-21 has been projected at 3.6 per cent.
70. Turning to economic activity, total area sown under kharif crops was 6.6 per cent lower as on August 2 than a year ago, with significant catching up taking place in recent weeks. Industrial activity continued to be weak in May 2019, impacted mainly by manufacturing and mining. In terms of use-based classification, growth of capital goods and consumer durables decelerated. However, growth of non-durables accelerated in May. The index of eight core industries decelerated in June. Merchandise exports and imports contracted in June. Seasonally adjusted capacity utilisation moderated to 74.5 per cent in Q4:2018-19 from 75.6 per cent in Q3. Based on early results of listed companies, demand conditions in the manufacturing sector remained weak in Q1:2019-20, with sales of manufacturing companies contracting by 2.4 per cent (y-o-y), caused mainly by petroleum, automobile and iron and steel companies. On the positive side, the Reserve Bank’s business assessment index (BAI) for Q1:2019-20 improved marginally. The manufacturing PMI rose in July, supported by a pick-up in production, higher new orders and optimism on demand conditions in the year ahead.
71. Several high frequency indicators for May-June also suggest weakening of services sector activity. Two key indicators of rural demand, viz., tractor and motorcycle sales, continued to contract. Among indicators of urban demand, while passenger vehicle sales contracted in June, domestic air passenger traffic growth turned positive in June after three consecutive months of contraction. Two key indicators of construction activity, viz., cement production and steel consumption, also contracted/slowed down. Import of capital goods contracted in June, suggesting weakening of investment activity. The services PMI moved into expansion zone in July on increase in new business activity, new export orders and employment.
72. GDP growth for 2019-20 has been revised downwards from 7.0 per cent in the June policy to 6.9 per cent – in the range of 5.8-6.6 per cent for H1:2019-20 and 7.3-7.5 per cent for H2 – with some downside risks. GDP growth for Q1:2020-21 is projected at 7.4 per cent. The impact of monetary policy easing since February 2019 and favourable base effects are expected to support GDP growth, especially in the second half of the year.
73. Liquidity in the system has been in surplus since June 2019 with the surplus absorbed under the reverse repo window of the Reserve Bank being almost `2.0 lakh crore on August 6, 2019. The past policy rate cuts have been fully transmitted to financial markets. The weighted average lending rate (WALR) on fresh rupee loans of banks has declined by 29 bps during the current easing phase so far (February-June 2019). The transmission to bank lending rates has been inadequate, though it is expected to improve in the coming weeks and months. Credit growth has

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slowed down somewhat in the recent period; credit to micro, small and medium enterprises, in particular, remains anaemic. 74. Overall, there is clear evidence of domestic demand slowing down further. Investment activity has been losing traction. The weakening of the global economy in the face of intensifying trade and geo-political tensions has severely impacted India’s exports, which may further impact investment activity, going forward. Private consumption, which has been the mainstay of domestic demand, has also decelerated. The slowing down of domestic demand is also reflected in significant moderation in CPI inflation excluding food and fuel; and contraction in merchandise imports.
75. In view of weakening of domestic growth impulses and unsettled global macroeconomic environment, there is a need to bolster dwindling domestic demand and support investment activity, even as the impact of past three rate cuts is gradually working its way to the real economy. With headline inflation projected to remain within the target over the next one-year horizon, supporting domestic growth by further reducing interest rates needs to be given the utmost priority. Given the current and evolving inflation and growth scenario at this juncture, it can no longer be a business as usual approach. The economy needs a larger push. I am, therefore, of the view that a reduction in the policy repo rate by conventional 25 bps will be inadequate. On the other hand, a 50 bps rate cut might be excessive and indicate a knee jerk reaction. A policy rate adjustment of 25 bps or multiples thereof may not always be consistent with the evolving macroeconomic situation. Hence, at times it is apposite to calibrate the size of the conventional rate adjustment. Considering these aspects, I vote for reducing the policy repo rate by 35 basis points and for continuing with the accommodative stance of monetary policy. The calibration of the size of the rate cut is expected to reinforce and quicken the impact of (i) the past cumulative rate reduction of 75 basis points; (ii) change in the stance from neutral to accommodative; and (iii) injection of large surplus liquidity in the system.

Transmission of interest rates
One is not sure why media and analysts are shy to disclose the truth that, of late, a change in base rate by itself doesn’t mean much for the economy in the Indian context. This could be because the banking system’s dependence for resources on RBI is not significant. But these are commonsense views which policy makers usually ignore. This time around, experts have similar views. This is what Madan Sabnavis, Chief Economist, CARE Ratings wrote in The Hindu Business Line on August 9:
“Since February there has now been a 110 bps reduction in the repo rate, of which, 75 bps came between February 7 and June 6. How have interest rates reacted? First, the weighted average interest rate on deposits came down from 6.91 per cent in January to 6.84 per cent in June. The weighted average lending rate (WALR) for fresh loans of all banks came down from 9.97 per cent to 9.68 per cent in June which is lower by 29 bps and hence a better response.” He further observed that the repo cost per se will not matter as it is applicable to not more than 1 per cent of NDTL (net demand and time liabilities) which is permissible under LAF (liquidity adjustment facility).
 So far, the message that a cut in base rate by, say, 25 basis points in base rate is an expression of expectation that banks will reduce lending and deposit rates by quarter percent or near-about has not gone down the line loud and clear. There are reasons for this. Banks are aware of this expectation. But we cannot ignore market realities. Banks’ term deposit rates have some relationship with  government’s own savings schemes like Provident Fund and National Savings Schemes. Savers expect a reasonably positive return on their savings, net of inflation. Till inflation starts flirting with zero or below, any reduction in retirement savings will mean a cut in the daily expenses of senior citizens. So, there are constraints in reducing deposit rates.
Despite all these, there exists a case for reducing lending rates, by reducing the need for high margins. If margins have to come down, efficiency in fund management, recovery rate and overall discipline in the  financial system should improve. Here, RBI will expect support from policy makers and judiciary.
There are indications that some banks may accept the challenge of linking their deposit and lending rates to the central bank’s base rate which may gradually earn some respectability for the repo rate.
Last 5 years have seen the Indian financial sector getting churned chaotically in unprecedented proportions. Contributing factors included diverse interests of depositors and borrowers, owners ( mainly GOI) and supervisors and regulators (represented by RBI) and the short-term views on long-term policy issues taken by political leadership represented by GOI.
In banking industry which is dependent on deposits from public for bulk resources, the bifurcation of institutions into public and private sectors for the purpose of regulation and supervision as also social responsibilities is fallacious. Aspects like the quality of management and the level of specialization in serving the clientele should differentiate institution ‘A’ from institution ‘B’ in the eyes of the public who make informed choices.
Instead of thinking in terms of quick-fix solutions like recapitalization and privatization, GOI should fast-track consolidation and infusion of professionalism in running public sector banks. The short tenures of Dr Raghuram Rajan, Dr Urjit Patel and now Dr Viral Acharya at RBI in a way benefited policy makers in Delhi. They received unbiased opinions about the ‘Do’s and Don’ts’ relating to the management of fiscal and monetary policies and supervision of institutions in the financial sector from independent celebrity economists.
Facing fiscal reality
Ever since Economic Survey 2016 erroneously estimated the quantum of RBI’s reserves inflating the figures by including fictitious revaluation reserves and ‘unilaterally’ suggested avenues for deployment of the assumed surplus, there have been clarifications and analyses including Dr Raghuram Rajan’s September 3, 2016 Delhi speech and Dr Rakesh Mohan’s three-part article published in October 2018 in Business Standard. The general impression is that the Centre may not be a net gainer by reducing the real value of RBI’s reserves as the government may have to find takers for the securities/assets RBI may sell to monetize unrealized revaluation reserves. In the public eye, the balance sheet of RBI will become weak as the central bank’s capital remains static at rs 5 crores and the balance sheet strength depends on its reserves in different ‘pockets’. 
In the fitness of things, statutory bodies should have functional freedom to manage their funds in a professional and transparent manner within the statutory provisions.
Way forward
The above discussion will remain inconclusive without a mention of measures which RBI and GOI should initiate to come out of the “Chakravyooha” created by inflation worries and slow down in growth. We do not need external talent to know that economic growth needs the fertilizer called resources or ‘investment’. At the risk of repetition, let us remind GOI about the huge unaccounted domestic gold stock waiting to be accounted and mainstreamed, real estate assets owned by governments and public sector organizations waiting to be revalued and managed efficiently to give reasonable rates of return and last but not least rationalizing the taxation system. If holders of huge domestic stock of gold invest a part of their stock with banks and central bank and banks at least double their gold components in reserves, there will be a multiplier effect in money available for lending without adverse impact on inflation.
India has several positives conducive for robust economic growth. Illustratively, our public debt (internal and external) is at manageable levels, we are not wasting money in financing wars, we have more friends than enemies and our political and economic stability remain at internationally acceptable levels,as of now. That RBI is well aware about the growth concerns is evident from governor's responses on different occasions. Please see excerpts from his speech of August 19,2019 reproduced alongside. 
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Excerpts from the Inaugural Address by Shri Shaktikanta Das, Governor,  Reserve Bank of India delivered at FIBAC 2019 – the Annual Global Banking Conference organised by Indian Banks’ Association (IBA) and Federation of Indian Chambers of Commerce and Industry (FICCI) in Mumbai on Monday, August 19, 2019 (Source: RBI Website)

Emerging Challenges to Financial Stability
The Indian Scenario
7. The pursuit of financial stability has always been a policy priority in India. The twin concerns of monetary and financial stability constitute the core objectives of the Reserve Bank. Similar to the global case, India also responded to the crisis by introducing changes in the existing institutional architecture to further the cause of financial stability. Recognising the various channels that could lead to systemic instability and the fact that different segments of financial systems are regulated by different regulators, the institutional mechanisms of the Financial Stability Development Council (FSDC), under the Chairmanship of the Finance Minister, and the FSDC sub-committee, under the chairmanship of Governor, Reserve Bank, have been fully functional. The biannual Financial Stability Report (FSR), a report of FSDC sub-committee, analyses the current state of financial system, the extent of interconnectedness among its various segments and possible sources of vulnerabilities that could impact domestic financial stability.

8. The headwinds to financial stability could emanate from various sectors of the economy, namely, (i) the credit market; (ii) financial markets; (iii) external sector; and (iv) payment system. It may emanate from some other sources as well. But today, I will focus on these four aspects.


Headwinds from Banking Sector
9. In India, the credit market is dominated by the banking sector which plays a key role in financial intermediation in the economy. Soundness of the banking system may have a bearing on the financial stability through various channels - excessive credit growth; maturity mismatches and liquidity issues; high proportion of non-performing loans; and overleveraging, among others. Even if individual institutions are robust, the overall behaviour of the financial sector can pose a systemic risk. Hence, monitoring the health of the banking sector is crucial for financial stability.

10. In recent years, as a result of efforts by both the Reserve Bank and the Government, the overhang of stressed assets in the banking system has declined. Going forward, the macro-stress tests for credit risk conducted by the Reserve Bank indicate that under the baseline scenario, the GNPA ratio may decline further by March 20202. Other indicators like the provision coverage ratio (PCR), capital adequacy and return on assets have also improved. I have earlier stressed that the real test of performance, efficiency, internal stability and governance improvement in public sector banks (PSBs) would be their ability to access capital markets rather than looking at the Government as a recapitaliser of first and last resort.

Financial Stability Report, June 2019, Reserve Bank of India.
11. Despite certain teething problems, the Insolvency and Bankruptcy Code (IBC) is proving to be a game changer. New norms for resolution of stressed assets framed in June 2019 by the Reserve Bank provide incentives for early resolution, with discretion to lenders on resolution


processes. The objective is to ring-fence future build-ups of NPA stress and protect the banking sector. The recent amendments to the IBC should also be able to facilitate faster resolution of stressed assets.

12. As we have seen in the recent past, the build-up of risks among regulated entities due to interconnectedness, exposure concentrations, non-transparent market practices, governance deficiencies, and their contagion effects have repercussions for financial stability. In this regard, the Reserve Bank is keeping a close watch on the interconnectedness of banks and non-banks. The Working Group on Core Investment Companies (CICs) has already started its deliberations and based on its recommendations, the Reserve Bank proposes to carry out necessary changes in the regulatory architecture for CICs. We are also in the process of building a specialised regulatory and supervisory cadre for regulation and supervision of banks and non-banks.

13. Another important issue in this context is the immediate need to strengthen corporate governance structure in banks, which I have elaborated earlier as well. This would include efficient functioning of their boards and board sub-committees, especially audit and risk management committees; robust system for monitoring of performance of MDs/CEOs; and, an effective performance evaluation system to improve the financial and operating parameters of banks. We have already sent our suggestions to the Government for governance reforms in PSBs. Overall, it is important that risk management systems, compliance functions, and internal control mechanisms are strengthened and made more dynamic.


Non-Banking Sector
14. Coming to the NBFC sector, we all know that this sector complements the banking sector and aspires to act as the bridge to provide last mile connectivity. Further, niche NBFCs fulfil the unmet and exclusive credit needs of infrastructure, factoring, leasing and other such activities. Non-traditional and digital players are now entering this space to deliver financial services by way of innovative methods involving digital platform. There is a web of inter-linkages of the NBFC sector with the banking sector, capital market and other financial sector entities. The Reserve Bank keeps a close watch on these inter-linkages to ensure financial stability. With a view to strengthen the sector, maintain stability and avoid regulatory arbitrage, the Reserve Bank and the Government have been proactively taking necessary regulatory and supervisory steps. It is our endeavour to have an optimal level of regulation and supervision so that the NBFC sector is financially resilient and robust. We will not hesitate to take whatever steps are required to maintain financial stability in the short, medium and the long-term.

15. Our objective is to harmonise the liquidity norms between banks and NBFCs, taking into account their unique business models. We are also looking at governance and risk management structures in NBFCs. Recently in May 2019, NBFCs with a size of more than 5,000 crores have been advised to appoint a functionally independent Chief Risk Officer (CRO) with clearly specified role and responsibilities. This is expected to bring in professional risk management to the working of large NBFCs.

16. The move to bring Housing Finance Companies (HFCs) under the regulatory ambit of the Reserve Bank is significant, given their asset-

liability profiles. Including HFCs, the size of the NBFC sector constitutes about 25 per cent of combined balance sheet of scheduled commercial banks. The Reserve Bank will take necessary measures to deal with these challenges.

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