RBI monetary policy review: Signalling only via rate cuts is not enough

Despite the 75 bp in cumulative repo rate cuts so far, growth momentum continues to flag. Are rate cuts not enough or are they not working? Both issues need consideration. 

Monetary policy works with long transmission lags. In India it typically takes two to three quarters for rate cuts to affect growth and transmission is most effective via the interest rate channel (financial market rates) and then the credit channel (via bank lending/ deposit rates). 

The former is working well, but the latter (credit channel) faces challenges. The fragile non-bank finance companies (NBFC) mean banks need to step up, but despite policy rate cuts banks have tightened their lending standards for the demand-hit segments such as small- and medium-sized enterprises, auto dealers and real estate, raising credit risk premium and partly muting the benefits of lower rates. 

We believe there are multiple ways to enhance monetary policy transmission.

First, through policy action and guidance (signal). Weak global demand, weak monsoons and still-tight domestic credit conditions weigh on consumption, suggesting that growth has weakened further in Q1 FY20 (Apr-Jun). Even with a recovery in the second half, we expect GDP growth to moderate to 6.5 per cent y-o-y in FY20, below the Reserve Bank of India’s (RBI) projection of 7 per cent. A negative output gap should keep inflation under 4 per cent and support lower rates. In addition, forward guidance that does not rule outfurther cuts could enhance transmission.

Second, this signaling should be complemented with the RBI’s liquidity stance. To its credit, the RBI has already shifted banking system liquidity into surplus. We believe there should be a follow-up commitment to keep banking system liquidity positive for the foreseeable future. 

Past evidence has proven that transmission works best when there is positive banking system liquidity during rate cuts and tight liquidity during rate hikes. 

Liquidity has a behavioral effect too. At a time when risk premium is high and financial stability risks are prevalent, positive liquidity can lower liquidity premia and gradually narrow credit spreads as liquidity slowly trickles down the risk curve (from AAA to AA, etc). 

A third option is to announce counter-cyclical macroprudential norms for specific sectors to offset higher credit risk premium. 

Finally, to address confidence issues, we think an asset quality review of the NBFC sector should be performed and revealed.

In addition to the above, there are many structural impediments to transmission that need resolving over time, including a shift towards an external benchmark-based lending rate system, encourage banks to offer floating rate deposits, faster reset period on banks’ floating rate loans, improving banks financial health, among others. 

One concern is that excess liquidity can trigger risky lending. However, if indeed we see signs of growth/inflation resurface, then liquidity may also be quickly withdrawn, in our view.

To summarise, the process of transmission, which has just started, needs to be reinforced through liquidity. Only signaling may not be sufficient. 

(The author is Chief Economist – India and Asia ex-Japan at Nomura)