Why This Is Urjit Patel’s Smartest Policy

Since Urjit Patel took over as the governor of India’s central bank in September 2016, he has presented four monetary policy reviews, including the latest one on 6 April. Undoubtedly, this is the smartest one.

The backdrop of the policy was abundance of liquidity making a mockery of the Reserve Bank of India’s (RBI) benchmark repo rate, or the rate at which the central bank lends money to the commercial banks, as the overnight rates as well as all short-term instruments were trading at lower than the repo rate.

It was given that there would be no change in the policy rate as well as the stance but the big challenge before the RBI was how to iron out the distortions and drain liquidity.

Here is how Patel has tackled this:

He has raised the reverse repo rate or the rate at which banks park their excess liquidity with the RBI by a quarter percentage point to 6%. Now it is a quarter percentage point lower than the repo rate. Similarly, the rate of marginal standing facility or MSF has been reduced by an equal quantum and brought down to 6.5%, a quarter percentage point higher than the repo rate. If banks want to borrow from RBI beyond what they have already borrowed from the repo window, they get money through the MSF at a higher cost.

Essentially, RBI has shrunk the liquidity corridor (reverse repo and MSF are the bottom and top tiers and repo is at the middle of the corridor) to 50 basis points or bps (6-6.5%). At one point, it was 2 percentage points (+/- 100 bps) which was subsequently brought down to 1 percentage point (+/- 50 bps).

What purpose does this serve? Even though the repo rate is the operative rate of the Indian central bank, it works effectively when banks borrow money from the RBI. But when there is too much liquidity in the system, the reverse repo rate becomes the anchor rate. Once the reverse repo rate is raised, the overnight rate as well as other short-term rates will rise (in fact, they rose on Thursday immediately after the announcement of the policy). When the liquidity is drained out in future, they will rise further as repo rate will become more effective. But in an extreme liquidity crunch, banks’ cost of borrowing will be capped at 6.5%, down from 6.75% (the MSF rate).

Incidentally, with the rise in the reverse repo rate, banks will also earn a quarter percentage point more when they lend money to RBI.

A narrower liquidity corridor will bring in more efficacy for the signal rates, dampen volatility, and translate into better transmission of the monetary policy.

Since this has been achieved, Patel doesn’t seem to be in a tearing hurry to drain the excess liquidity. This could have been done by raising the cash reserve ratio or CRR but that would have affected banks’ earnings as they do not earn any interest on the money kept with the RBI in the form of CRR. He has also not announced any immediate bond selling under the market stabilisation scheme (MSS) to drain liquidity but said the entire tool kit would be used to soak up liquidity, including the standing deposit facility, as and when the government gives its approval and amends the RBI Act, a precondition for creation of this new instrument.

A subtle pressure on the government for its nod on the new instrument as well as paring the small savings rate for better transmission of the monetary policy is unmistakable in the policy document.

Patel has also played his other cards smartly. While the stance of the policy remains neutral, there is no indication of going back to an accommodative stance or a rate cut in the near future. Indeed, retail inflation will remain much below the 5% target in the last quarter of the just concluded fiscal year 2017 (it was 3.65% in February, the March figure is not yet out) but the average inflation is projected to be 4.5% in the first half of 2018 and 5% in the second half.

Instead of feeling happy about taming inflation for now, Patel is distinctly worried about rising inflation later this year for multiple reasons—uncertainty over the trajectory of the monsoon and its impact on food inflation, the house rent allowances awarded by the 7th Pay Commission for central government employees, the fallout of goods and services tax (GST) coming into play this year, the impact of farm loan waivers on the government’s fiscal deficit as well as the base effect.

Is he “overcautious” or “hawkish”? That’s a question of semantics. The fact remains that RBI will continue with its neutral stance for the time being and the chances of a rate cut even in the second half of the fiscal year are slim. For the time being, the overnight and short-term rates will remain in the range of 6% and 6.25% (between reverse repo and repo) and when the liquidity dries up completely and banks are in acute need of money, the rate will rise to 6.5% without any tinkering by the RBI (the MSF rate). Had he not cut the MSF rate, it would have risen to 6.75%.

Bankers should have no reason to complain.

This column first appeared in www.livemint.com

Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of A Bank for the Buck, Sahara: The Untold Story and Bandhan: The Making of a Bank.

His Twitter handle is @tamalbandyo.

To read his earlier columns, log onto www.bankerstrust.in