That the Reserve Bank of India (RBI) would not cut its policy rate in the August bi-monthly review was almost a given. To that extent, there was no surprise in the monetary policy review on Tuesday. Far more interesting than the 2,175-word review was the statement that RBI governor Raghuram Rajan read out (it was roughly one-third of the policy review, in length) at the customary press conference after releasing the review. It ended intriguingly. “This is my last policy statement, but there are still 28 days in my term which I intend to use fully,” Rajan said.
This reminds me of one of the iconic dialogues of Bollywood—“Picture abhi baaki hai mere dost” (There’s more to come in the picture, my friend; Shahrukh Khan in Om Shanti Om).
So while the policy review does not have much to say, there could be plenty of action at the Indian central bank between now and 4 September when Rajan steps down as RBI governor. He mentioned three specifics: guidelines for peer-to-peer (P2P) lending and account aggregators, a set of measures to kick-start the corporate bond market (which will happen on 25 August) and a revision of the banks’ marginal cost-based lending rate, or MCLR.
Introduced in April, MCLR was intended to ensure that banks pass on the benefit of lower cost of money to borrowers by paring their loan rates. They haven’t been as fast in doing so as the governor expected them to in current liquidity conditions.
The banks’ tardiness at this point is probably linked to concerns over redemptions expected to start next month of close to $26 billion in foreign currency non-resident (bank), or FCNR (B), deposits that banks raised three years to support the rupee when it was in a free fall. “Earlier, some bankers said that it was the lack of liquidity that was holding rates high, now I hear from some that it is fear of the FCNR(B) redemptions that is making them reluctant to cut rates. I have a suspicion that some new concern will crop up once the FCNR(B) redemptions are behind us,” Rajan commented sarcastically. All of us know that ever since RBI started aggressively pushing the banks to clean up their balance sheets, the biggest current concern of the Indian banking industry is the pile of bad loans. This makes banks fearful of giving new loans and restrains their ability to pare loan rates as they need to set aside money to take care of bad loans. As this dents their profitability, they are not willing to compromise on their interest income—what they have been earning from their standard assets. At the same time, because they are not making good profits (and many of them are, in fact, posting losses), they are not able to bolster their capital which, in turn, crimps their ability to lend.
The measures that Rajan plans to announce before he steps down have one objective—to make money available for those who need it and force banks to cut their loan rates. If we have a vibrant corporate bond market, banks will be forced to cut their loan rates as borrowers will have another platform to raise money. Currently, 90% of the entities that raise money in an extremely thin corporate bond market are AAA-rated. A few AA and A+ rated entities do raise money through bonds but the rest, even those with investment grade ratings, cannot access the bond market as the subscribers to such bonds are scared of defaults.
The necessary infrastructure to make the proposed bankruptcy code effective is one of the building blocks of a deep corporate bond market. Another essential ingredient is the credit default swap, or CDS, also known as a credit derivative contract which transfers the credit exposure of fixed income products such as bonds between two or more entities. It is a sort of insurance against default. A CDS buyer makes payment to the seller of the swap and in the event of any default the seller is required to ensure that the buyer’s earnings are protected.
At the moment, there is a capital charge when a bank buys CDS and because of this the CDS market is not developing as banks need to assign more capital if they dabble in this derivative instrument. The banks want the capital requirement to be reduced by netting off the exposure of the buyers and the sellers of CDS. Simply put, if Bank A is buying Rs.100 worth of CDS from Bank B, which already had a Rs.80 exposure to Bank A, then it needs to assign capital for only Rs.20 and not Rs.100. RBI needs to amend the rules to ensure this. Pending the amendment, it is exploring whether this can be done through a notification.
The central bank is also looking at partial credit enhancement to encourage development of the corporate bond market. Currently, in case of a default, banks can protect up to 20% of their exposure to a bond through the credit enhancement mechanism in terms of securities and guarantees, etc. provided by the borrower (issuer of a bond). The RBI will probably double this while keeping a single bank’s maximum limit at 20%.
All these will add depth to the corporate bond market. The RBI also plans to make corporate bonds acceptable at its liquidity window as collateral. Currently, banks can borrow from RBI offering government bonds as a collateral; once this is done, they will be able to borrow using corporate bonds as collateral, and this will encourage banks to build their corporate bond portfolio. However, the RBI Act needs to be amended for this.
We will eagerly wait for the 25 August announcement to see what the central bank can do to develop the corporate bond market, pending such amendments. The bimonthly review has been in sync with market expectations—there is no change in the policy rate or banks’ cash reserve ratio, the central bank’s accommodative stance as well as its year-end inflation target (with an upside bias). From a liquidity-deficit banking system we have already migrated to a liquidity-plus system and Rajan has reaffirmed his commitment to continue with this stance. Since the beginning of the fiscal year, RBI has pumped in a little more than Rs.80,000 crore into the system and it will continue to do so through buying bonds, popularly known as open market operations, or OMOs. On Tuesday, it announced the latest round of OMOs. Reacting to that, bond yields dropped.
When shall we see the next round of rate cuts? From Tuesday’s statement, a rate cut in October does not seem a certainty although Rajan said RBI has been waiting for space for policy action. Retail inflation measured by the headline consumer price index (CPI) rose to a 22-month high in June, mainly driven by food prices. A normal monsoon and the base effect will cap its rise and disinflation in services—for the first time this dropped below 5% in June since the introduction of the new CPI formula—will create room for the next rate cut.
The proposed six-member Monetary Policy Committee for which RBI has already selected its three members will most probably be in place before the next bimonthly review in October. In his statement, Rajan said, “With the formation of the MPC, the government and RBI will have completed a fundamental institutional reform, which modernizes India’s monetary policy framework and builds a platform for strong and sustainable growth.” The other three members will be chosen by the government. Each member of the committee will have one vote and the RBI governor will have a second or casting vote in case of a tie. So, a lot will depend on who is the next governor when it comes to the timing of the next rate cut.
