Following MPC line, onus on government to revive economy

Reserve Bank of India

The Reserve Bank of India’s (RBI) first monetary policy review of fiscal 2017-18 was presented last week amidst expectations of a status quo on the interest rates and speculation of action on a few irritants like the problem of excess liquidity. As expected, the repo rate was left untouched. Surprisingly, the reverse repo rate was increased by a quarter percentage point to six percent and the marginal standing facility (MSF) rate was reduced by an equal amount to 6.5 percent.

The reverse repo rate was increased to mop up the excess liquidity that has accumulated with the banks post-demonetisation. In a system with excess liquidity, the repo rate, or the rate at which commercial banks borrow from the central bank, becomes ineffective as banks already have surplus cash. In such a situation, the reverse repo rate, or the rate at which commercial banks park their excess liquidity with the central bank, becomes an effective policy tool.

As the RBI has reduced the gap between repo and reverse repo rate from 50 to 25 basis points, the range in which the overnight rate at which banks lend each other has reduced as well, and it expectedly rose following Thursday’s announcement. This should reduce the liquidity in the economy as banks will move to park their funds with the central bank. Such a move was more nuanced than the traditional approach of raising the cash reserve ratio (CRR) to tackle excess liquidity as banks would not have earned any interest on money kept in the form of CRR with the RBI.

Apart from the use of reverse repo rate, the Monetary Policy Report also indicated various measures to maintain liquidity neutrality such as variable repo rate operations, open market operations, issuing cash management bills and market stabilisation bonds. Further, the government is also examining the prospect of implementing the Standing Deposit Facility, under which banks can park funds with the RBI without receiving bonds as collateral.

Meanwhile, the central bank left the repo rate unchanged due to a few upside risks to inflation in the new fiscal year. These include a possible El Nino, the effects of the 7th Pay Commission payouts and the implementation of the Goods and Services Tax (GST). Also, a rise in aggregate demand due to remonetisation and return to normalcy of cash-intensive sectors will add to inflationary pressures. Considering these factors, the role of monetary policy seems pretty limited in this financial year.

The RBI has done its best with the limited tools at its disposal to control inflation and address the problems that have been ailing the economy. Now, the onus is on the government to revive growth along with supplementing the RBI’s efforts in containing inflation. However, the current financial year has been off to a bad start on that front.

As RBI Governor Urjit Patel pointed out, the Uttar Pradesh government’s decision to waive off farm loans worth Rs 36,369 crore has significant long-term implications for the economy that might prove inimical to the central bank’s goals. First, such a move creates moral hazard among borrowers as it removes any incentive for repayment. An economy already burdened with the problem of bad loans can ill afford such a systemic undermining of its credit culture.

Second, it forces other state governments to either offer similar waivers or lose political ground. This can already be seen in Maharashtra and Tamil Nadu, where similar loan waivers will soon see the light of day. Third, it adds to government debt that will end up borrowing more and, in the process, crowding-out private borrowers. Such a scenario will hurt any growth prospects that the Indian economy possesses. Rising government debt will also add to the inflationary pressure that the RBI has been desperately trying to contain.

The Indian government needs to steer clear of such ill-informed policy decisions that only serve short-term political gains. A larger picture of reviving the economy in consonance with the RBI needs to be followed. To begin with, the government needs to urgently roll out the plan to tackle the problem of NPAs that it has been working on with the RBI. The issue of stressed assets has constrained transmission and credit flow, which has been hurting India’s growth and also reducing the effectiveness of RBI’s policies.

Also, as the RBI warns in its report, inflation needs to be closely observed and food prices need to be kept in check. This is a clear message to the government to curb inflation and inflationary expectations, especially through the supply-side, over which the RBI has no control. Finally, the government must be wary of the temptation of misusing fiscal policy for short-term gains, considering that it is the only policy tool at the economy’s disposal in the near future.

All of the central bank’s efforts since the last few years to manage liquidity in the economy and anchor inflationary expectations will be rendered useless if the government does not work in tandem with its policy actions. No amount of rate changes by the Monetary Policy Committee can help the economy in that case.