RBI’s New Trinity

RBI's Trilemma

Tame Inflation, Ensure Liquidity, Sustain Credit Growth

Hike in Repo Rate, CRR: Reserve Bank of India (RBI) surprised the market by raising the policy rate (repo rate) by 40 bps and increasing the cash reserve ratio to 4.5%.. Element of surprise is because, Monetary Policy Committee (MPC), which was originally scheduled to meet in June, conducted an off-schedule meeting from 2nd May to 4th May 2022 and conveyed its decision to hike the repo rate to 4.40% (kept unchanged at 4.0% for nearly 24 months). Immediately thereafter, the price of bench mark govt security came down by about Rs.1.75 and the yields there of, went up by 26 bps. Not to be undone, commercial banks, both public sector banks (PSBs) and private sector banks (PvBs), raised their repo linked lending rates exactly by 40 bps, though it is another matter that the said banks were never known for borrowing from RBI at repo rates in the past. Kotak Mahindra Bank raised its interest rates for depositors by 30-35 bps and other banks are likely to follow suit.

RBI's new Trinity: While making the above changes, RBI Governor Shri Shaktikanta Das made a significant statement that monetary policy remains accommodative and withdrawal of pandemic related extraordinary accommodation will continue to be calibrated, keeping in mind the inflation-growth dynamics. RBI will also ensure adequate liquidity in the system to meet the productive needs of the economy.

But whether RBI will succeed in the new trilemma of taming inflation, while ensuring adequate liquidity and facilitate ideal conditions to remain for a continued bank credit  growth? In this regard, I am neither an economist nor a practising banker, but using the experience gained in my banking days, present the following:. 

Trinity 1. Ensuring liquidity uninterrupted: RBI sucked out nearly Rs.87000 cr. from the banking system by increasing the cash reserve ratio (a fixed percentage of net demand and time liabilities to be maintained by banks with RBI) from 4 to 4.5%, effective from the fortnight beginning May 21, 2022. Though this may appear contrary to the stated objective of maintaining adequate liquidity, the move was done more to drain out the excess liquidity as evidenced by the following:

i.       Average surplus liquidity in the banking system, reflected through SDF and variable rate reverse repo (VRRR) auctions, was ₹7.5 lakh crore during April 8-29, 2022.

ii.       The weighted average call money rate (WACR) – the operating target of monetary policy – dipped below SDF rate, due to excess  funds parked under SDF.

iii.     The favourable response of banks to 14-day and 28-day VRRR auctions as well as the USD/INR sell-buy swap auction conducted on April 26 suggests that system-level liquidity remains ample.

So, in a system with an average excess liquidity of Rs.7-7.5 lac crore, the impact on account of increase in CRR is expected to be minimal only.  It is also to be noted that the slew of liquidity measures announced by RBI from time to time in the last two years, to ensure that credit to identified sectors do not suffer, still continues. Refinance facilities from NABARD. NHB and SIDBI are available up to the indicated amount, at repo rates. Marginal Standing Facility (MSF) can be drawn up to 3% of DTL (1% more than the normal 2% of DTL -nearly Rs.1.74 lac crore). RBI can always bring in the facility of Variable Term Repo along with the daily fixed rate repo to meet the needs of individual banks. In addition to the above measures aimed at of specific banks' liquidity needs, RBI can always chip in with OMO purchases, Operation  Twist and USD/INR swap arrangements to improve the liquidity in the banking system as a whole. As such, liquidity tap looks uninterrupted.

Trinity 2. Sustaining Credit Growth: When the lending rate goes up, one has to see whether there will be decline in credit growth or increase in stressed assets (due to increased interest costs/EMIs) or both. For that, one needs to look at the growth story last year.

In the period March 2021 to February 2022, Gross Bank Non-food Credit has grown by Rs.6.70 lac crore. (growth rate of 8%). The major contributions came from medium enterprises (71%), micro and small enterprises (20%) agriculture and allied activities (10.5%) trade (14%) NBFCs (15%) unsecured  personal loans (22%), gold loans (26%) housing (7%) and vehicle loans (10%). Agriculture and allied activities are inelastic to change in repo rates, as they are mainly fixed rate loans. In respect of others, loans, which are secured primarily or covered under guarantee schemes are made available at cheap and affordable rates. Hence an increase of 40 bps might not affect their capacity of servicing the interest and repayment obligations substantially. As regards unsecured loans, which are offered at relatively higher interest rates, the increase in EMI, on account of 40 bps increase, may be marginal as compared to their present EMIs.  It is also worthwhile to note that the outstanding under SMA1 and SMA2  reported by the banks for the quarter ended March 2022 are much less over the previous quarter.

In the above circumstances, increase in lending rates at the levels indicated by the banks so far (up to increase in repo rate) may not affect the credit growth/increase the stressed assets in the above sectors. But the story may turn different, if RBI choose to increase the repo rate still further, in the coming months.

Trinity 3. Taming Inflation: RBI mainly adduced the following for the increase in inflation: 

1.     The Russian-Ukraine War, resulting supply shortages/dislocations and volatility in commodity/financial markets.

2.     Debt distress is rising in the developing world amidst capital outflows and currency depreciations.

3.  Normalisation of monetary policy in major advanced economies is gaining pace significantly – both in terms of rate increases and unwinding of quantitative easing as well as rollout of quantitative tightening. (especially USA)

4.  Global crude oil prices are ruling above US$ 100 per barrel and remain volatile. The direct impact of the increases in domestic pump prices of petroleum products – beginning the second fortnight of March – is feeding into core inflation prints. 

5.  Global wheat shortages and export restrictions on edible oil by key producing countries may have an impact on the domestic prices of these two commodities.

6. The sharp acceleration in headline CPI inflation in March 2022 to 7 per cent was propelled, in particular, by food inflation due to the impact of adverse spill overs from unprecedented high global food prices. Nine out of the twelve food sub-groups registered an increase in inflation in March. High frequency price indicators for April indicate the persistence of food price pressures.

7.    The risks of unprecedented input cost pressures translating into yet another round of price increases for processed food, non-food manufactured products and services are now more potent than before.

In addition to the above, unannounced coal shortages and  reports that procurement of wheat for PDS is lower due to market prices ruling higher than MSP in some of the major states producing wheat, may have a spiralling effect on inflation.

Fiscal Support needed: In order to preserve macroeconomic and financial stability, MPC said it decided to raise the repo rate by 40 bps. The question is whether monetary action from the part of RBI alone is enough to restore macroeconomic stability? In my view, both Central and State Governments have a huge role to play in the following areas

a.    In reducing crude oil prices. One remembers, when the global crude oil prices were ruling at less than USD50-60 for a considerable period of time since 2015, the consumer was not passed on the benefit and the retail price was kept constant, by jacking up the central excise duty and state tax. Both Direct Tax and GST collections have registered record growth in 2021-22. As mentioned by RBI, the increase in domestic pump prices of petroleum products have impacted agriculture, industry and retail consumers alike. The significant jump in direct and indirect tax collections gives the centre the flexibility to review duties and tax on petroleum products in consultation with states and reduce the charges on a long term basis. This will help revive the economy faster.

b.   Coal Shortage: Almost all the states are facing the heat. Non supply of coal to non-power sectors like steel, cement, sponge iron is one of the reasons for the increase in the price of the said materials and this will have an impact all around including infrastructure and realty sector. There is an urgent need to address the issue if price stability is to be maintained.

c.      Managing Food supply: Due to restrictions on edible oil by a few countries, increased global prices for fertilisers, wheat, etc. majority of the food items are ruling at record high prices.

Conclusion: While monetary policy has played an effective role in sustaining growth and optimism during pre and post COVID period, it may not be able to contain inflation without the support of fiscal measures from the government. The success of the three factors of the new trinity viz. liquidity, credit growth and inflation control (within +/-2 range of 4%) depends on price stability. Increasing the repo rate, though may not affect growth and liquidity in the first phase, may prove insufficient in the long run, unless it is supplemented with support from the government, in the form of fiscal initiatives. Any increase in repo rate from now on, without corrections on the supply side, reductions in tax/duties, etc. may result in de-growth in credit, increase in stressed assets and ultimately strain the liquidity available in the system. It may also increase fiscal deficit as the cost of govt. borrowings will go up in a repo rate hike scenario.

V.Viswanathan

07th May 2022

New Trinity