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Monetary policy and regulatory issues - Outside View by S.S. TARAPORE

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Monetary policy and regulatory issues
Mar 24, 2014

On the economic policy front, all eyes are on the Reserve Bank of India's (RBI) monetary policy of April 1, 2014, which will be the first bi-monthly review for 2014-15. Traditionally, the April review also covers important regulatory and operational issues.

Growth, inflation & external sector outlook

It is now increasingly clear that there will be no easy way of reviving growth in 2014-15. The first quarter of the year (i.e. April- June 2014) will be taken up by the General Elections and their aftermath and hence, revival of growth, if at all, would be primarily in the second half of 2014-15. Agricultural outlook is uncertain, with possibilities of an El Nino effect resulting in a poor monsoon. Furthermore, firm green shoots of industrial revival are yet to be seen. It would be best, therefore, to work with a real GDP growth in 2014-15 of say 5.5 per cent.

Inflationary pressures have somewhat abated, with the year-on-year Consumer Price Index (CPI) inflation for February 2014 at 8.1 per cent (lower than the 8.8 per cent increase for January 2014). The Wholesale Price Index (WPI) inflation, on a year-on-year basis for February 2014 was 4.7 per cent (as against 5.1 per cent in January 2014). A major problem in India is that we are all too eager to prematurely pronounce victory over inflation and the cheer squads on the sidelines egg on the RBI to start easing monetary policy. With the need to raise administered prices, sooner rather than later, and the fiscal position as revealed by the Interim Budget for 2014-15 painting a far better picture than what the fisc really is-with acceleration of revenue and gross underestimating of expenditure in 2013-14, the throw forward effect on the fisc would obviously be adverse in 2014-15.

While the balance of payments current account deficit (CAD) in 2013-14 appears to be surprisingly low, at around US $ 40 billion (2.3 per cent of GDP), there are two worry lines. First, while gold imports have significantly reduced after the curbs on gold imports, there is strong anecdotal evidence, including data from the World Gold Council, which points to a quantum jump in illicit imports of gold, but there does not appear to be a large reduction in inward remittances. What is worrisome is whether there is a major lacuna in the data. Secondly, exports are slowing down and the overvalued exchange rate would appear to be a factor dampening exports. While a sharp depreciation would, at the present juncture, appear not feasible from a political economy viewpoint, it could be a drag on exports.

In the recent period, there has been a sudden upsurge in foreign portfolio capital inflows into India. The experience, the world over, is that large portfolio inflows are followed by large capital outflows. Foreign Institutional Investments (FIIs) outstanding are estimated at US $250 billion, equivalent to 25 per cent of market capitalisation. The FIIs essentially trade in about 70 active stocks and in these companies, the FIIs account for 75 per cent of the free float (i.e. shares other than those held by promoters).Thus, the Indian stock market is highly dependent on FIIs' activity. Hence the euphoria about the bullish trend in the Indian market needs to be tempered with caution.

Monetary Policy Measures for April 1, 2014

Given that the RBI policy repo rate of eight per cent is close to the present CPI inflation rate, there is no question of reducing the policy rate. Bank honchos erroneously believe that a reduction in policy rates would revive activity and the fortunes of the banks themselves. This thesis is questionable. Ideally, the RBI accommodation interest rate should be between the one-year deposit rate and the base lending rate. On prevailing deposit and lending rates, the RBI accommodation rate needs to be increased. While present political economy imperatives may not be propitious for an increase in the RBI policy rate, some restructuring of RBI accommodation could be considered. The quantitative limit fixed for the overnight repo could be lowered and the limit for the 14-day repo could be correspondingly enhanced. In the recent period, there are too many RBI accommodation windows - overnight, 14-day, 28-day and recently 21-day - quite apart from the marginal standing facility and the stand-by liquidity facility. There should be a gradual switchover from the overnight repo to the 14-day repo, which should then become the key operative policy rate. A first step towards this could be initiated on April 1, 2014.

Regulatory measures

The April 1, 2014 policy will also carry some regulatory measures. Some of the issues set out below could also be given attention:

  • Non-Performing Assets (NPAs): The experience has been that banks go through a cycle of deterioration. Since the early 1990s, the government has poured in large amounts of capital into public sector banks (PSBs). Mere injection of capital into the PSBs is not sufficient. So long as the basic malady continues, the weak PSBs will have a periodic resurgence of the problem of increased NPAs. It is time that an alternative strategy is considered. One has to be cruel to be kind and the only option is to significantly curb the growth of the weak banks.

    Such a strategy would bring about effective damage containment. If the present system of periodic injection of capital is continued, the weak PSBs will, over time sink the Union Budget. The weak banks should be required to limit their deposit growth to low-cost deposits and the bulk of the banks' funds should be in government securities and credit growth should be severely curtailed. In effect, these banks should gravitate to becoming payments banks. Unusual problems need unusual remedies.

  • Licensing of New Private Sector Banks: The issue of granting licenses to new private sector banks was first mooted in the Union Budget of February 2010.The detailed consultative process has taken long for understandable reasons. Since the start of the general elections is only a fortnight away, the final announcement of the granting of licences should be deferred till after the new government is formed. An announcement of granting of licences in the immediate ensuing weeks would get the RBI caught into a vortex of political crossfire. Here is a case where a tactical delay would be in the best interests of the system.

  • Safeguarding Depositors' Interests: Depositors are the true owners of banks and safeguarding their interests should be the paramount objective of regulatory policy. Invariably, corrective action is delayed till depositors' funds are eroded. This calls for early regulatory action at the incipient stage of erosion of banks' capital and reserves. Again, the overall interest rate policy should be based on adequately compensating depositors, rather than treating them as poor relatives in the system.

Please Note: This article was first published in The Freepress Journal on March 24, 2014. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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