Rate cut unlikely but a dovish policy on the cards

In March and May, the Reserve Bank of India (RBI) went for out-of-turn policy rate cuts following off-cycle meetings of its rate-setting body, the Monetary Policy Committee (MPC). This week, the Indian central bank will take a call on its policy rate after a three-day meeting of the MPC.

Following the last rate cut, the RBI policy repo rate, or the rate at which it infuses liquidity in the banking system, is four per cent; and the reverse repo rate, the rate at which commercial banks park extra liquidity with the RBI, is 3.35 per cent. Both are now at their historic lows.

Since March, the RBI has cut its policy rate by 115 basis points. One basis point (bps) is a hundredth of a percentage point. Will it go for yet another rate cut?

For Governor Shaktikanta Das, this is probably the toughest monetary policy since he took over the assignment. Should the RBI cut the rate as the risks to the growth outlook for Asia’s third-largest economy are still grave? If it does so, there won’t be too many bullets left in Das’s chamber.

On the other hand, if it doesn’t and the market gets the impression that the rate-cutting cycle is over, bond yields will rise, raising the cost of government borrowing. Currently, the real interest rate at which the government is borrowing money is negative.

The message of the August policy then is more important than the action.

Let’s take a closer look at the MPC’s dilemma. Why shouldn’t it go for another rate cut when the growth outlook is so uncertain? In May, the MPC felt that headline inflation might remain firm in the first half of financial year 2021 but should ease in the second. The Governor in May had stated: “If the inflation trajectory evolves as expected, more space will open up to address the risks to growth.”

Driven by the so-called core — or non-food and non-oil — inflation, the retail inflation in June was 6.09 per cent, more than one percentage point higher than the consensus estimate. The inflation numbers for April and May, based on imputed calculations, were 7.2 per cent and 6.3 per cent, respectively. The average retail inflation in the first quarter of 2021 is 6.5 per cent, higher than all estimates. Against this backdrop, can the RBI cut the policy rate?

If the RBI cuts the rate, there won’t be too many bullets left in Das’s chamber

At the same time, the RBI needs to convince the market that it is not through with the rate cut cycle as yet; that this is just a pause. Retail inflation will come down in the second half; the average could be 3.5 per cent, well below the RBI’s target.

The hike in fuel price is behind us; food inflation may not rise as the supply chain glitches are being taken care of; and core inflation too may subside as there is no telltale sign of demand pick-up as yet. The RBI can keep the rate cut on hold for now and once the data confirm lower inflation in the second half, it could explore the possibilities of stretching the rate cut cycle.

The other option is a token 10 basis points cut, bringing the repo rate down to 3.9 per cent and reverse repo rate to 3.25 per cent. I would like to believe this won’t happen. It’s not even a close call. The RBI will hold on to the rates but keep the option open and the policy document will say this emphatically. It will be a dovish policy, without a rate cut.

The average daily liquidity in the system, which was around Rs 7.5 trillion at its peak, is now around Rs 6 trillion. Banks have been paring their loan and deposit rates but there is room for transmission still. The spread between 364-day treasury bill yield and the average interest rate on one-year bank deposit has widened to 1.9 percentage point. When did we last see this? Not in this decade.

The biggest challenge before the RBI is managing the government borrowing programme, raised from budgeted Rs 7.8 trillion to Rs 12 trillion to bridge the higher fiscal deficit. In the first half of the year, Rs 5.16 trillion has been raised out of an estimated Rs 6 trillion. Exercising greenshoe options, Rs 58,000 crore have been raised on top of regular auctions. Also, Rs 2.04 trillion flowed through one-year treasury bills (the comparable figure for the previous year: Rs 68,000 crore). And, the RBI has bought bonds worth Rs 1.21 trillion through open market operations.

Since there is ample liquidity in the system, managing the central government’s borrowing may not be very difficult but those of the state governments can queer the pitch.

Beyond interest rate and liquidity management, the RBI may also tinker with the composition of banks’ bond portfolio to shield any mark-to-market, or MTM, loss in case the interest rates rise. MTM is an accounting practice of valuing the bond portfolio at the current market price and not the price at which they were bought.

Banks are required to invest 18 per cent of their net demand and time liabilities, a loose proxy for deposits, in government bonds but the average bond holding of the industry is far higher — at least 29 per cent. Banks can keep 19.5 per cent of bond holdings in the so-called “held to maturity”, or HTM, basket, not exposed to any risks of rising interest rate.

The rest — kept in the “available for sale” and “held for trading” baskets — runs the risk of price fluctuations. Bond yields and prices move in opposite directions. If the yields rise and prices fall, the banks would need to provide for the value erosion. The RBI may raise the HTM limit to encourage banks to buy more bonds.

Another contentious issue is extension of moratorium on repayment of loans beyond August and allowing banks to restructure loan accounts affected by the Covid pandemic. Should the moratorium be extended in top cities where businesses are more affected than other parts of the country? Should the extension be for certain industries or stressed accounts across industries, leaving it to the discretion of banks? The RBI may wait till August-end to plan its action.

The writer, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd

To read the writer’s previous columns, please log onto www.bankerstrust.in

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