Eight years ago, when Dr Manmohan Singh was serving his second term as Prime Minister and India’s retail inflation neared 9%, the central bank chose to have a hard look at the liquidity adjustment framework to make its rate signals more effective.A panel headed by Reserve Bank of India executive director Deepak Mohanty suggested that the liquidity adjustment facility operate in a deficit mode, with the repo rate, the rate at which RBI lends to banks, being the single policy rate to unambiguously signal monetary policy stance. Citing an example, the panel said a 100 bps change in the repo causes around 80 bps change in the weighted average call rate (WACR) over a month. However, the strength of the response turns out to be relatively small in a surplus liquidity situation. In theory, the job of the central bank is to anchor the overnight call money rate around the policy rate. While this objective works better in developed economies, it remained pretty wayward in India over the last decade.Keeping liquidity “in deficit” is easier said than done.The banking system was awash with funds after demonetisation when humble savers were forced to dig out money kept under the mattresses and deposit them in banks. Former Governor Urjit Patel did his bit to suck out liquidity and restore normalcy, but then lost his chair for sticking to his ground on “slightly deficit” liquidity even after the non-bank credit crisis of 2018, antagonising the government. Patel had a rift with the fiscal authority on issues such as the fate of RBI’s excess reserves and central bank autonomy.His successor Shaktikanta Das, who initially followed the 2011 liquidity guidance, has now flagged expectations of easier flow of funds, setting up an internal working group that will review the existing liquidity management framework, suggest measures to simplify the system, and clearly communicate the objectives, quantitative measures and toolkit of liquidity management. The group is expected to submit its report by mid-July. System liquidity was in surplus of ?16,500 crore at the end of last week vs ?49,500 crore in the previous week.CHANGE IN CONTOURSLiquidity in the system turned into an average daily surplus in June after remaining in deficit during April and most of May due to restrained government spending. RBI said that transmission of the cumulative reduction of 50 bps in the policy repo rate in February and April 2019 was 21 bps to the weighted average lending rate (WALR) on fresh rupee loans. Interest rates on longer tenor money market instruments remained broadly aligned with the overnight weighted average call rate, reflecting near full transmission of the reduction in policy rate.The central bank lowered the policy rate by another 25 bps on June 6, making it the straight third rate cut in the year. The central bank has also changed its stance to accommodative from neutral, which means there would be no possibility of a rate hike in the near horizon. More critically, Das said that the central bank would ensure adequate liquidity in the system for all productive purposes.MARKET GIVES A THUMBS UPThere are many options for the new committee. The Reserve Bank’s MPC could be advised to look beyond the WACR to gauge the liquidity situation in the economy.“Like major central banks, MPC should look at the entire term structure of money market rates to gauge the efficacy of its liquidity stance,” said B Prasanna, head of global markets groups at ICICI Bank. “Second, RBI may ease the daily CRR maintenance framework from the current 99% compliance to 80% or so. This will be indirectly relaxing CRR without officially cutting it. This will improve the banking liquidity condition.”Corporate bond yields in the secondary market in April and May were lower than the lending rate of banks, indicative of the faster transmission of the RBI rate cuts in the bond markets. Corporate bond yields (weighted average in the secondary markets) were 9 bps lower than the banks’ marginal cost-based lending rate (MCLR) in April and 44 bps lower in May, said CARE Ratings. The 10-year government securities benchmark yield has also declined by about 56 basis points from its average in April 2019 to about 6.86%.The softening of bond yields in the secondary market and the consequent softening in the cost of borrowing in the primary market coincided with a rise in bond issuances. Prime Database showed an 86% monthly jump in volume to Rs 45,539 crore in May. The weighted average cost of issuances in the primary market was 13 bps lower at 8.49% compared to the month-ago rate.At the heart of the mismatch between the RBI’s policy and the banks’ failure to pass on the benefit to the borrowers is the slowdown in household savings.“Deposit rates became soft in June as compared to the rates in April. But they are not as soft as was expected by the regulator. This is because small savings rates still remain elevated. A correction is needed in small savings rates for better transmission of monetary policy,” said Allahabad Bank chief executive director SS Mallikarjuna Rao.The transmission in lending rate was restricted merely to new loans. The weighted average lending rate on outstanding rupee loans rose by 4 bps as past loans continue to be priced at high rates.“Increased government borrowing and elevated small savings rates have rendered deposit mobilisation by banks expensive. Also, India’s consumption demand is still not a pronounced credit fuelled or leveraged demand,” Sunil Kumar Sinha, principal economist at India Ratings and Research, said ahead of the third rate cut of the year.The situation at the current juncture has become further complicated due to the crisis in both the banking and the non-bank sectors. While banks are saddled with about 11% of their loans turning bad, NBFCs are struggling with solvency issues leading to credit freeze.This creates a sense of déjà vu. Easier fund flow in inter-bank system in the yesteryears has led to credit underwriting crisis more often than not. RBI, which is at the cusp of cleansing the banking sector balance sheet after a four-year fire-fighting, should not allow it go waste.RBI may do well in harmonising the definition of liquidity and create a more effective communication channel among itself, market players and the government.“The market often confuses between the liquidity availability with the willingness of entities to lend to one another, which is an independent commercial decision,” said CARE Ratings chief economist MadanSabnavis.Rationalisation of market expectations and new ideas and tools are essential, but at the core of the operating framework is monetary transmission.
from Economic Times https://ift.tt/2X06rEF
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