Monetary Policy: Das’ Draghi Encore Comes With Risks

In October 2019, the Monetary Policy Committee of the Reserve Bank of India, faced with a shocking gross domestic product growth number of 5 percent, decided, “to continue with an accommodative stance as long as it is necessary to revive growth”.

We had likened that comment to a famous remark made by Mario Draghi.

At the height of the Euro currency crisis in 2012, the European Central Bank chairman Draghi made this comment at a conference in London, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

The ECB Chairman had mentioned this having already announced several measures to quell the sovereign bond crisis including announcing its own version of quantitative easing – long-term repo obligation or LTRO in December 2011.

Troubled with the seemingly continued lack of monetary transmission—a term to denote, the cumulative impact of lower repo rates onto lower lending rates—the RBI announced that it will conduct long-term repo operations, of 1-year and 3-year tenor, to the tune of Rs 1 lakh crore. This is done to “facilitate the transmission of monetary policy actions and flow of credit to the economy. And with a view to assuring banks about the availability of durable liquidity at reasonable cost relative to prevailing market conditions”.

New Avatar RBI Dons Its Old Hat

What was even more interesting, is that the governor began the press conference, by noting that although the markets had already ‘discounted’ the expected pause on repo rates and the continuing of the accommodative stance, but they would do well to not ‘discount’ the RBI. The RBI has enough tools to not only address the growth slowdown but to also drive credit delivery and monetary transmission.

Sure enough, the bond market which was almost unchanged on the announcement of status quo on rates and stance, rallied sharply on finding the mention of LTRO in the Part-B of the announcement which deals with developmental and regulatory policies.

For some of us old timers, it was a pleasure to see a RBI ‘credit’ policy instead of a RBI ‘monetary’ policy.

Thursday’s announcement had so much more in the good old, oft-forgotten aspects of central banking – market development; sector specific credit interventions; liquidity framework; supervision and regulatory changes.

As I have noted earlier, in my column and comments on BloombergQuint, this is a bold new RBI in a bold new avatar.

Many Tools In The Kit Put To Use

Their bold efforts over more than a year through rate cuts; stealth liquidity initially through huge open market operations and then through foreign exchange swaps; to adopting an external benchmark for lending rates; and now sector specific regulatory dispensation, are – must say – bearing fruit.

They even announced ‘Operation Twist’ – buying long-term government bonds and selling short-term bonds – ostensibly (as they articulated today) to drive corporate bonds lower. My assessment of Operation Twist was that the RBI was telling the markets that it does not have room to cut rates but it still wanted to support the government’s fiscal expansion.

But the two issues that Operation Twist had:

1. It was not committed and markets could not not anticipate the size and the duration of the operations; and
2. Operation Twist was indirect bankrolling of the government’s fiscal expansion; seemed to have given rise to this idea of LTRO.

With LTRO announced, Operation Twist should cease.

Making The LTRO Work

The LTRO provides the banks with durable money (Rs 1 lakh crore), over a defined tenor (1- and 3-year) and at a pre-defined rate (5.15 percent).

Banks have the following choices with it:

• Buy government bonds with that money, at a small spread over the repo);
• Buy high-quality corporate bond at a slightly higher spread;
• Take slightly higher risks by buying or lending to lower-rated corporates and NBFCs;
• Bail out the liquidity-starved, solvency-challenged corporates and NBFCs.

We know from academic history that a central bank cannot solve a solvency or confidence issue with rate cuts or liquidity infusions.

As the LTRO is over and above the existing excess liquidity situation though voluntary, it is essentially a tool to force monetary transmission through stealth. The LTRO will, if nothing, at least aid in getting short-term bond yields down across the government and corporate credit curve.

The Downside Of Excess Liquidity

So with excess liquidity to the tune of Rs 2-3 lakh crore since June; bank lending moved to an external benchmark; and now the LTRO – we should expect monetary transmission to gather pace and lead to further fall in bank lending rates as well. The dream of the government, to see home loan rates at 7 percent, as they were during the early years of UPA, seems to be fructifying.

The old timers amongst us will though worry about what risks do these moves engender to the system? Most of the bond market credit problem stemmed from the demonetisation-triggered liquidity infusion, with mutual funds taking on more credit risks in their bond portfolios. The age-old bank NPA problem that we face even today, has largely been an outcome of the credit rally after the Lehman Brothers crisis when the RBI flooded the market with excess liquidity. Many also point to the RBI actions post-Lehman—of sharp rate cuts and excess liquidity—as sparking the inflation cycle that we saw between 2010 and 2012.

The RBI needs to be watchful of its actions and needs to ensure that in its exuberance it should not risk an already fragile credit economy.

Arvind Chari is Head – Fixed Income & Alternatives at Quantum Advisors. Views expressed are personal. Disclaimer

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.