The Osmosis Communication in RBI monetary policy

Given that inflation will stay elevated in the next couple of months, a rate cut in Feb and April is ruled out, at least logically

The Reserve Bank of India’s (RBI’s) decision to maintain the status quo has taken the market by complete surprise. The markets do not like unexpected news and to that extent yields have jumped. However, markets must interpret it as a temporary pause just akin to biological osmosis. 

In a similar vein, the current pause with an accommodative stance could just be an attempt to allow the impact of surplus liquidity and transmission to permeate through the system. But in the same vein, given that inflation will stay elevated in the next couple of months at close to at least 5.3-5.4 per cent, a February and April cut is ruled out at least logically. Thus, it might be a longer pause.

We, however, believe the RBI might have taken the cue from the Reserve Bank of Australia, that defines the inflation target as a medium-term average rather than as a rate (or band of rates) held always sacrosanct. Experience in Australia and elsewhere has shown that inflation is difficult to fine-tune within a narrow band. 

The economic performance of Australia has still then been excellent. Average inflation in Australia since 1995 is 2.7 per cent, very close to 2.5 per cent mid-point with no record of recession in 25 years! 

Interestingly, in conjunction with 75-basis-point (bp) rate hike followed by a 135-bp rate cut in two years, banks monetary transmission is evolving. The 1-year median MCLR (marginal cost of funds-based lending rate) has declined by 49 bps during this period and this will gather faster pace as rates are reset every quarter. We believe the market fascination with “Operation Twist” is unjust. 

Operation Twist implies that the RBI is expected to buy long-term securities and simultaneously sell short-term securities so that the long ends of the yield curve and short end is more aligned. Currently, in FY20 so far the RBI has purchased 67 per cent of securities with more than 5 years’ tenure through OMO. Clearly, the RBI is already doing enough of “Operation Twist” to manage the yield curve expectations. 

Furthermore, the RBI also does switch from short-term to long-term that is exactly the opposite of “Operation Twist” whereby yields on long-term securities are expected to rise. Additionally, given the low demand for credit any such incremental OMO purchase will only reduce money multiplier further. 

The regulatory steps taken in the policy for UCBs (urban cooperative banks) are most welcome. Specifically, the extension of the Central Repository of Information on Large Credits for UCBs will result in a new regime of lending discipline. 

The RBI has also prescribed a new comprehensive cyber security framework for UCBs. In order to give a fillip to the Peer-to-Peer (P2P) lending sector where NBFCs carry out their business, the RBI has increased the lending cap for each individual lender.

At last, we believe that the government in conjunction with the RBI should consider a pragmatic step of setting up a stressed fund to address the problems in the NBFC sector. 

There is now a significant risk that if too much time elapses, NBFCs will further reduce their assets, thus elongating the credit crunch. The positive aspect of not setting up a stressed fund could be that things might just have bottomed out! Let’s hope the latter! 

Views expressed are personal