In its bi-monthly Monetary Policy Committee’s (MPC) review announced by Governor Shaktikanta Das on December 8, 2021, the Reserve Bank of India (RBI) has kept the policy repo rate or RR ( interest rate at which it lends money to banks) unchanged at 4 percent. It has also kept reverse repo rate or RRR (interest rate on the surplus cash kept by the banks with it) unchanged at 3.35 percent. Besides, it has retained an ‘accommodative’ policy stance as long as necessary.
This is the ninth consecutive time that both the policy rates have remained unchanged since August 2020. Justifying the decision, Das observed “given the slack in the economy and the ongoing catching-up of activity, especially of private consumption, which is still below its pre-pandemic levels, continued policy support is warranted for a durable and broad-based recovery”.
Pertinently, in the review announced in August 2020, he had justified maintaining low rates (then also, both RR and RRR were kept unchanged at 4 percent and 3.35 percent respectively) along with “accommodative” stance – as long as necessary – in terms of the need to revive growth and mitigate the impact of Covid-19, while ensuring that inflation remains within the target.
On both the occasions, low interest rate and accommodative stance (a euphemism for enough availability of credit or liquidity in short and low cost of credit) has been posited as instruments of supporting growth –during 2020-21, for reviving it and now for ensuring durable and broad-based recovery.
Is this really so? Did this strategy help in 2020-21 or even earlier? Is it working during the current year?
In the backdrop of the slide in the real Gross Domestic Product (GDP) growth that had commenced in the third quarter of the financial year (FY) 2018-19, during 2019, the RBI had delivered a cumulative cut in RR of 1.35 per cent in five installments, the last one being under the policy review on October 4, 2019. This resulted in lowering of RR from 6.5 per cent at the start of the year to 5.15 per cent. The apex bank also pumped liquidity using instruments such as Open Market Operations (OMO). Yet, FY 2019-20 ended with growth of a mere 4.2 per cent (during the last quarter, this was 3 percent).
Following the onslaught of Covid – 19, on March 27, 2020, the apex bank reduced RR by 0.75 per cent and further 0.4 per cent on May 22, thus affecting a total cut of 1.15 per cent. It also injected aggregate liquidity close to Rs 500,000 crore through measures such as reduction in the cash reserve ratio (CRR), auction of Targeted Long-Term Repo Operations (TLTRO), hike in accommodation under the Marginal Standing Facility (MSF) and so on.
Despite this massive booster – on top of the boost already given during 2019-20 – there was de-growth of 7.3 percent during 2020-21 (in fact, during the first quarter it was minus 24 per cent). During the current year, even as the low RR continues and there is plenty of liquidity (currently, excess cash in the banking system is around Rs 920,000 crore), GDP growth during the first quarter recorded 20.1 percent and 8.4 percent during the second quarter. However, to see a connection between the two is untenable. Had a loose monetary policy been a potent factor, then we would have seen good growth even during the previous two years.
The most crucial determinant of growth is demand (including investment demand) which was slack during 2019-20 and annihilated particularly during the first half of 2020-21, courtesy Covid pandemic. As a result, despite the policy rate on a downward trajectory reaching a record low of 4 percent in May 2020 and RBI pumping tons of money, there was deceleration in growth in both the years. The rebound during the current year has to do primarily with substantially diminished effect of the pandemic and revival of demand, though fragile.
Another factor impeding growth during 2019-20 and 2020-21 was lack of full transmission of the rate cut announced by the RBI. For instance, during 2019-20, of the 1.35 percent reduction in RR, only about 0.6 percent was transmitted by banks by way of corresponding reduction in the lending rate. This has a lot to do with their non-performing assets (NPAs) apart from the fact that a bank can’t ignore the interest rate it pays on deposits which is downward sticky; courtesy, much higher rates on small savings schemes.
The growth of credit too has been slack despite the RBI arming banks with tons of liquidity. During 2019-20, bank credit grew by 6.1 percent, less than half of the 13.4 per cent growth registered during 2018-19. During 2020-21 also, it continued to be sluggish at 5.6 percent. That apart, a big chunk was cornered by big corporate even as most of the small businesses had their shutters down; even those who operated didn’t get access due to the reluctance of banks to lend.
During the current year also (when GDP is in recovery phase), credit growth has not picked up pace, this being 5.8 percent during the first quarter. The micros, small and medium enterprises (MSMEs) continue to be prime laggards. They have still not fully utilized the money available under Emergency Credit Line Guarantee Scheme (ECLGS) sanctioned last year under the Atmanirbhar Bharat Abhiyaan. Against the limit of Rs 450,000 crore, as on September 24, 2021, the amount availed is Rs 286,000 crore.
Without doubt, the efficacy of monetary policy in addressing the problem of slack growth is in doubt. The RBI/MPC may have applied pause button on the policy rate but it continues with its ‘accommodative’ policy stance which does not rule out the possibility of either a further reduction in RR or pumping more liquidity or both. Any of these actions is strongly ill-advised as without any guarantee of propelling growth, it will result in two big negative outcomes.
One, by signaling reduction in lending rates, this will force banks to further reduce deposit rates. This will erode the income of millions of depositors who have already suffered due to reduction of at least 2 percent thanks to RR cuts in the past. For those, whose sole income source is interest earning from deposits, this will be suicidal.
Two, this will run the risk of stoking inflation. Inflation – as measured by consumer price index (CPI) – is expected to stay elevated around 5.5 percent – 6 percent through 2021-22. Already, this is at the higher end of the medium-term target of 4 percent (+/- 2 percent). If, RBI were to continue with its generosity (read: accommodative stance), this could result in inflation getting out of control.
In this backdrop, it is encouraging to see the RBI making some moves to suck out excess liquidity in the system by raising the amount of cash it absorbs through the 14-day VRRR (Variable Rate Reverse Repo) auction. This process should continue till all of the excess is erased. It should also consider restoring RR to 5.15 percent – the level that prevailed prior to the onslaught of pandemic.
While, these measures will bring cheer to depositors and public at large by reining in inflation, for sustaining high growth, the Government should rely on rationalizing/trimming taxes and replacing subsidies by direct income support to boost demand.