New Flexible RBI, Aware of Cost of Regulations

What Indonesia's central bank had done in January, the Reserve Bank of India (RBI) did on Friday — a policy rate cut despite the pressure of the local currency’s depreciation against the dollar.

Of course, there is a difference. While the rate cut in Southeast Asia's largest economy to fuel growth was unexpected, in India, the world’s fastest-growing major economy, it was on expected lines. As inflation is easing, the growth-inflation dynamics have changed in favour of a growth push.

The RBI reduced its policy repo rate by 25 basis points (bps) to 6.25 per cent in the first rate cut since May 2020, when it had gone for a 40-bp reduction to 4 per cent amid Covid. This was also the Indian central bank’s first rate action since February 2023, when the rate had been raised to 6.5 per cent. One basis point is a hundredth of a percentage point.

However, there has been no change in the monetary policy stance, which continues to be neutral. Theoretically, at this point, yet another rate cut in the next Monetary Policy Committee meeting in April is not a given, as the stance remains neutral against the backdrop of several uncertainties facing the global economy.

The policy, RBI Governor Sanjiv Malhotra’s first, has not given any forward guidance.

?This explains the reaction of the bond and forex markets. Since there was no clarity on future rate cuts, or to use a cliché, as the policy was not as dovish as many expected, bond yields rose 5 bps to 6.70 per cent. For the same reason, the rupee didn’t depreciate against the dollar despite the rate cut. In fact, the local currency appreciated 15 paise to close at 87.43.

The deferment of the new liquidity coverage ratio (LCR) framework also dampened the sentiment of the bond market, as it postponed the demand for bonds needed to maintain LCR. Yet another reason for a rise in bond yields was the absence of any fresh liquidity measures by the RBI.

Governor Malhotra, however, stated that the RBI was committed to providing sufficient system liquidity. It would monitor the evolving liquidity and financial markets and proactively take appropriate measures to ensure orderly liquidity conditions.

While the RBI projected India’s real gross domestic product (GDP) growth at 6.7 per cent for 2025-26, for the current year, instead of giving its own projection, it mentioned the first advance estimates of the National Statistical Office — 6.4 per cent.

In the December policy, the RBI had pared its FY25 GDP growth projection to 6.6 per cent from 7.2 per cent after a fall in growth rate to 5.4 per cent in the second quarter.

As for inflation, the policy kept its estimate for the consumer price index (CPI)-based inflation rate unchanged at 4.8 per cent. Assuming a normal monsoon, the CPI-based inflation rate for next year was projected at 4.2 per cent.

Going beyond the rate cut and projections for growth and inflation, the policy statement and the governor’s interaction with the media highlighted many interesting points which illustrate a new approach to banking regulations. The overarching theme of the policy was “flexibility”, and probably it was for the first time that an RBI governor talked about “cost” of regulations.

Referring to the proposed regulatory changes regarding LCR, expected credit loss (ECL) framework and prudential norms for banks’ exposure to infrastructure under implementation, the governor’s statement said: “Just like there are no free lunches, regulation to enhance stability and consumer protection too is not devoid of costs. There are trade-offs between stability and efficiency.”

Keeping this trade-off in mind, the RBI is not in a hurry to go for these regulations.

Introduced in the wake of the global financial crisis to control and monitor the liquidity of financial firms, LCR acts as a bank’s life support in the face of crises. It is a metric that ensures banks have enough cash to cover short-term liquidity needs.

ECL marks a shift from the traditional “incurred loss” to “expected loss” accounting method, where banks estimate potential credit losses based on forward-looking assessments instead of waiting for defaults to take place.

The RBI’s draft guidelines for project financing propose to jack up provisions at least 12 times during a project’s construction phase — and harmonise the norms across the lending community.

These are being kept on hold to give the banking system sufficient time to prepare itself for the new regime. The soonest the LCR could be implemented is April 2026, instead of the current plan of April 2025.

Despite these positives, why did the Bank Nifty – an index tracking the performance of the most liquid and large capitalised Indian banking stocks – fall? It’s elementary, my dear Watson. Following the cut in the policy rate, banks’ net interest margin (NIM), a key driver of profits, will be under pressure.

About 40 per cent of bank loans are given at an external benchmark-linked rate (EBLR) like repo and/or 364-day treasury bill yield. The cut in the policy rate will force banks to cut their EBLR. But the existing deposits will continue to earn the current rate; even for new deposits, it will not be easy for the banking system to pare rates as they need money to lend.

At his post-policy interaction with the media, Malhotra stuck his neck out on “India’s potential growth rate of above 7 per cent”. If one connects this with his focus on flexible inflation targeting in the changing growth-inflation dynamics, one can expect more rate cuts once the rupee stabilises against the dollar. Yes, there might be another rate cut in April despite the neutral stance.

Responding to a question, Malhotra, an IAS topper, spoke of students aiming for either pass marks of 40 or full marks of 100 in an examination. For his first monetary policy, he gets 100. Of course, though he has not yet completed two months in his new role, Malhotra is not exactly a student of a central banking course; he has been on the RBI board for some time now.

This column first appeared in Business Standard

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