Mint Street veterans claim that the tea served at the central bank has magical properties; it can convert even the fiercest critics into fans for life. This mythical story counts current Reserve Bank of India (RBI) governor, Shaktikanta Das, among those transformed.

When Das took the lift to RBI’s 18th floor, on 12 December 2018, to take over as governor, the central bank had already been through plenty of turmoil and turbulence, with public spats and bickering occupying headlines. Das was expected to provide calm, reach out to key financial system stakeholders, hold the wheel and steady the keel. Expectations from him were simple: steer the central bank back to the straight and narrow and don’t protest about the finance ministry. He has largely lived up to those expectations.

But the corona pandemic seems to be changing all that: the virus could transform RBI’s genetic architecture, in the same way it is changing how we work, play or party.

Das has now gone beyond the brief; judging by all the signals and noises emanating from Mint Street, Das is trying to remould the central bank by taking back some of the discretionary controls lost to the monetary policy committee (MPC) in 2016, mandated by an amended RBI Act. Das has managed to take limited rate actions outside the MPC. The question is: how far can he push this envelope?

This may be his toughest test yet. The signs of a silent struggle within RBI are apparent in the way it has danced around the edges of the crisis, impatiently waiting for smoke signals from the finance ministry or the Prime Minister’s Office.

The stage

Over the past 12-18 months, as the crisis in Mumbai’s financial markets has progressively intensified, RBI’s measures—primarily indirect intervention through the money and government securities markets—has failed to move markets.

Even the package of measures to counter the covid-19 induced economic slowdown has left the markets cold. This is forcing Das to also change the central bank, albeit at a glacial pace.

In the February policy meeting, while the MPC voted to hold rates, RBI introduced “development” measures that sought to indirectly reduce lending rates. Das later commented: “…it is important not to discount the RBI…the central bank has several instruments at its command…to address the challenges that the Indian economy currently faces…even though the present monetary policy decision is constrained by elevated inflation pressures, there are other ways in which the RBI can strive to revive growth.”

Juxtapose this with the governor’s public statements that RBI will be conducting an internal review of how the MPC has worked, which will be followed up by extensive stakeholder consultations. He even reiterated it during Mint Annual Banking Conclave 2020.

In Das’s defence, though, it must be said that he did not—and could not—anticipate the financial sector’s continuing state of crisis since December 2018. Extraordinary demands have been made on the central bank in these past 16 months, with expectations in some cases far exceeding its ability or mandate.

What began with IL&FS defaulting on its loan repayments and continued through DHFL, PMC Bank, Altico Capital and Yes Bank crises, has now been amplified by the novel coronavirus. These financial sector problems were compounded by large companies going bust (such as Jet Airways) or regulatory policy threatening to trip up an entire industry (telecom), leading to potentially large loan defaults.

The Indian financial services industry’s fault lines lie fully exposed. With Franklin Templeton now shuttering six mutual fund schemes without repaying all investors, there’s a fresh crisis emerging from another quarter.

The playbook

The problem is Das has been handed down an abridged playbook, inadequate for tackling both the financial sector meltdown as well as the pandemic. Flexible inflation targeting became the central bank’s sole compass after disparate voices in Delhi and Mumbai, that had long bristled at RBI’s operational autonomy, finally found a receptive audience in the Narendra Modi-led government.

Every other central banking activity has become subsidiary to this single objective, prompting even former governor Y.V. Reddy to comment in an interview to BusinessLine: “The issue now is whether the governor is responsible only for inflation. But the governor of the RBI is responsible for many things and so if he delivers on inflation and muffs up everything else, are we happy?”

Das is obviously displeased with the way things have gone so far, with only inflation under control and everything else pretty much in tumult.

The architect of the flexible inflation targeting, former RBI governor Urjit Patel, expressed his dismay with Das’s modus operandi in a recent piece in The Indian Express: “In a highly unpredictable time such as this, the RBI should preserve its inflation credibility. This requires making the institution of MPC more enduring, not bypassing it.”

RBI’s overriding strategy these past months has been primarily two-fold: keep reducing the benchmark rates in the hope it will be pushed down along the transmission chain, and, to inundate the system with excess liquidity. The objective is to induce credit demand through lower interest rates, which includes trying to nudge the financial sector to shake off its risk aversion. Also, to eliminate repayment defaults for want of refinancing (which also has an inflationary impact on rates).

Unfortunately, this has failed to move the needle.

The pandemic

In the wake of the covid-19 outbreak, RBI has come out with an array of monetary, liquidity and regulatory measures to ensure liquidity funds flow to the economy’s affected sectors. Unlike other central banks, RBI has adopted tools that seek to keep markets liquid and provide assistance to market agents indirectly.

These include long-term repo operation at cheap rates (in which RBI lends to banks against collateral of government securities for a fixed period) to induce banks to lend to industry; open market operations (in which RBI buys and sells government bonds in the market) to keep the economic system flush with cash and interest rates low; and exempting banks from cash reserve ratio (CRR, a portion of deposits that banks need to keep with RBI at no cost) on incremental credit disbursed to specific sectors.

Then there’s two tranches of $5-billion dollar each sell-buy swap (RBI sold dollars to banks with the agreement to buy it back in six months to ensure that forex market is adequately supplied with dollars and exits by foreign portfolio investors does not cause undue currency volatility); and an additional set of repo operations (Targeted Long Term Repo Operations, TLTROs) so that banks have money to buy up investment-grade bonds, among other measures.

These are all in addition to the deep cut in repo rates—down from 6.5% in December 2018 to 4.4% now, a reduction of 210 basis points in 16 months—and liquidity injection of close to 3.5% of GDP (about 7 trillion) plus a slew of measures allowing regulatory forbearance.

But the markets have barely blinked, or even paused for course correction. Yields on 10-year bonds have moved up 22bps between 11 March and 27 April, signifying the liquidity infusion has failed to allay risk perceptions in the market. The first auction of state government bonds managed to raise only 32,560 crore against a planned 37,500 crore. The yields also surged across the board, with Kerala government borrowing 15-year paper at 8.96%, which is about 200bps higher than a 15-year central government bond.

Specifically, poor drafting of some of the measures even left the markets confused. For example, RBI’s loan moratorium policy, allowing banks to overlook repayment delays, has left bankers divided, needed multiple clarifications.

Banks are also disappointed with RBI’s recent measures on provisioning and stress resolution. RBI has asked banks to make 10% provisions for all loans under the three-month moratorium announced on 27 March and said banks will get 90 more days to resolve assets under the 7 June 2019 circular.

The additional provisioning norms will hurt profitability and, ultimately, capital, bankers said. “When the RBI governor announced the moratorium, everybody jumped with joy, only to realize later that it comes with the rider of enhanced provisioning. The fear is that a large chunk of my capital may be wiped out because of the 10% additional provisioning,” said the chief of a public sector bank on condition of anonymity.

The fallout

Some of the market expectations are also being moulded by the crisis response of global central banks.

In the US, the Federal Reserve has decided to buy mortgage-backed securities, commercial paper, muni bonds and low-rated corporate bonds. The US central bank also set up facilities to provide federally guaranteed loans to small businesses that pledge not to lay off workers.

Other central banks, such as European Central Bank and Bank of England, have also continued with their bond buying programme, which is currently at record high levels. The Bank of Japan has pledged to buy unlimited amounts of government bonds to cap borrowing costs at zero. The central bank now owns nearly half of Japan’s government bond market.

“RBI could look at a bond buying programme like the Federal Reserve where the central bank decided to buy corporate bonds directly from corporates albeit with the support of the government. If RBI is unwilling to do that, it should look at opening up of the repo facility for corporate bonds for a wider set of counterparties like mutual funds, insurance companies etc,” said A. Prasanna, economist at ICICI Securities Primary Dealership.

In comparison, RBI’s measures have been cautious and limited. “RBI has allowed banks to buy investment grade corporate bonds and hold them till maturity. You have taken care of market risk. But who is taking credit risk? Credit risk needs to be addressed. Other countries are giving 6-month forbearance whereas we are giving only 3 months,” said a senior bank official on condition of anonymity.

Clearly, Mint Street signals are incapable of piercing the fog of covid-induced paranoia. There are reasons for it.

The first is a long-standing issue: there are limits to how much can be achieved through only central bank policy action. The government’s new economic theology has come to lean on RBI a bit too heavily for delivering all the goods, including economic growth.

Unfortunately, RBI’s repeated rate cuts and liquidity injections have set in motion a law of diminishing returns. Das is aware of this and even spoke about it in a public speech: “Monetary policy, however, has its own limits. Structural reforms and fiscal measures may have to be continued and further activated to provide a durable push to demand and boost growth.”

There’s a second fault line: markets are clearly expecting the central bank to take direct action, to keep the monetary policy framework based on indirect instruments in abeyance. The market’s expecting a back-stop of sorts, a safety net that will catch falling repayments. In short, it wants RBI to guarantee all repayments for the moment. This also emerged in a recent Mint survey of chief finance officers of leading companies, bank treasury heads and economists.

This is also pushing Das to look at other options that do not involve the MPC. The central bank has so far managed to make some of the changes—such as, reducing reverse repo rate to 3.75% on 17 April to dissuade banks from dumping excess cash with RBI—without going through the MPC but also without breaching the RBI Act.

With covid tightening its deadly grip on India and markets getting restless for some quick and effective policy action, it needs to be seen whether RBI starts taking interest rate decisions outside the monetary policy framework with greater frequency. At the moment, though, it seems the central bank is still waiting to follow the government’s lead. But with India’s fiscal package delayed inordinately, when compared with other countries, RBI’s over-wrought monetary framework seems to be fraying at the edges.


News Source: Livemint


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