Does India need Unconventional Monetary Policy?

The Reserve Bank of India (RBI) has reduced its policy rate by 1.35% (135 basis points) during this calendar year, but that has provided little respite to the real economy. I think there are two issues here.

1. First of all, this so-called 135 basis point cut is an exaggerated number because the base for this calculation is the high point of the policy rate of 6.50% in August 2018. At least in retrospect, it is clear that the rate hike in mid 2018 was a mistake which took too long to correct. (In this context, the MPC dissents of that period are fun to read). The more appropriate measure of the rate cut is therefore to ignore the aberration of mid 2018 and focus on the reduction from 6.00% in August 2017 to 5.15% currently to arrive at a number of 85 basis points. Of course, 85 basis points is not to be scoffed at, but my point is that thinking about 85 as if it is 135 has probably made the RBI reluctant to cut rates more aggressively. Had the RBI actually cut rates by 135 basis points from 6%, we would have reached 4.65% instead of 5.15%.

2. Second is the stunning lack of monetary transmission: 10-year Indian government bond yields today are roughly where they were in August 2017 implying zero pass through of the 85 basis points cut in the policy rate. That is the most optimistic measure of monetary transmission because it focuses on risk free rates. Corporate borrowing is what is more relevant for capital investment in the economy, and here the situation is a lot worse because of a dysfunctional banking system that is unable or unwilling to lend for a variety of reasons.

As a result of this lack of monetary transmission, some people appear to have given up on monetary policy as a weapon to revive the economy. These people have started thinking that lower interest rates are simply pushing on a string, and that is better to rely on fiscal policy or supply side reforms. This in my view would be a cop out. Monetary policy has many other weapons still left in its armoury. After the Global Financial Crisis, when central banks in advanced countries found that they could not rely on interest rates because they had hit the zero lower bound, they did not give up. They used unconventional monetary policy that injected liquidity into the system and alleviated the credit crunch in the economy. The RBI should do the same if it thinks that policy rate cuts are not having an impact.

There is a lot that the central bank can do to push the 10-year government bond yield down by say 100-150 basis points to a level more consistent with the current state of the economy. First of all, the RBI could make a “lower for longer” commitment. It appears to me that the mistake of mid 2018 has dented the credibility of the central bank, and the markets are worried that as in 2018, policy rates could be raised again at the slightest pretext. Via the expectations channel, this fear would obviously stunt the monetary transmission to longer term rates. If the central bank could address this concern, and make a credible commitment that it would be more cautious in raising rates, 10-year yields would likely come down substantially. If jawboning the markets does not work, the central bank could simply buy enough long term government bonds to push the yield down to the desired level. Of course, such a policy is incompatible with an interest rate defence of the currency, and necessarily implies a willingness to let the rupee find its level.

What is even more pressing is the need to insulate the real economy from the debilitating effect of a dysfunctional banking system. The problem has been with us since the early 2010s, but for some time, the credit needs of the economy were met by near-banks (NBFCs). During the last year or so, the crisis in near-banks has shut down this channel and we are left with a dysfunctional financial sector (at least when it comes to credit). It is the responsibility of the central bank in situations like this to create mechanisms to maintain the flow of credit.

The RBI likes to acts through banks, but unfortunately, at this point of time, banks (and near-banks) are part of the problem and are definitely not part of the solution. The only feasible channel for maintaining credit flow today is the financial markets. I am convinced that the RBI should provide abundant systemic liquidity through the markets. Instead of complaining about the lack of deep bond markets, the RBI could use this as an opportunity to deepen these markets by acting as the market maker of first resort in a variety of credit markets and the buyer of last resort in key systemically important credit markets. The prime target for asset purchases by the central bank would be high quality residential mortgage backed securities and other securitization instruments, as well as senior tranches of Collateralized Loan Obligations (CLOs) that meet desired quality standards. The advantage of limiting asset purchases to pools of credit (and their tranches) is that it avoids charges of favouritism to individual borrowers. (The European Central Bank has been buying individual corporate bonds, but I doubt that Indian bond markets have the institutional maturity to make this possible.) When it comes to repo-lending, liquidity enhancement and market making, the RBI can target a far wider range of credit instruments.

Any measures that the RBI takes to promote financial markets would be welcome because India urgently needs to transition to a more market dominated financial sector for two reasons. First, Indian per capita income, GDP size and economic sophistication have all reached levels where it is natural for the financial sector to gradually shift from banks to markets. Second, the governance problems in banks and near-banks (whether in the public or private sector) have cast serious doubts about the viability of a bank dominated financial system in India at this point of time.

Posted at 7:28 pm IST on Thu, 7 Nov 2019         permanent link

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