The first decision on rates by the panel does not inspire much confidence

Quite predictably, a good part of the media and a good number of commentators have applied ornithological metaphors to describe the 25-basis points cut in the policy rate by the RBI in its fourth bi-monthly monetary policy review for this fiscal held on October 4. ‘ The inflation hawk has gone - and the doves on Mint Street have started to flap their wings’ - commented one daily. The policy repo rate is now 6.25 per cent – a six-year low. The RBI expects the transmission of this cut in lowering the costs of new borrowing in the economy will be more effective than the earlier cuts.

In one respect, the fourth bi-monthly policy review exercise this year is historic: it involved the maiden decision-making by RBI's first Monetary Policy Committee(MPC), in pursuance of a primary mandate to keep consumer inflation between 2 per cent and 6 per cent. That the adoption of a legally backed inflation-targeting discipline and the constitution of an MPC will enhance both the process and quality of monetary policy-making is widely acknowledged. However, it is equally important for the MPC to establish its institutional credibility by demonstrating that its decision-making framework is logical, consistent, transparent and effective. Gauged by those standards, the first rate decision of the MPC does not inspire much confidence, though.

No explanation

None of the documents compiled by the RBI in connection with this policy review, including the one on the post-policy conference call with media, clearly explains the rationale and necessity of the rate cut. In fact, it is hard to reconcile some of the key points and facts contained in those documents with the decision. The table shows the baseline projections of RBI for CPI inflation and GDP growth as of the fourth quarter of 2016-17 and 2017-18 that were made in the last two Monetary Policy Reports (MPR) - of April, 2016 and September, 2016.

Clearly, there has been an up-tick in projected future inflation during the last six months, while the growth outlook continues to be robust. The latest round of surveys conducted by RBI corroborate these projections. The household survey put the expected inflation in three months and 12 months at 9.5 per cent and 11.4 per cent respectively. During the period between September 2006 and June 2008, when current inflation expectations were low, the future inflation expectations were also low. In the recent past, however, despite a reduction in inflation, both current and future inflation expectations are elevated.

It is hard to figure out how, under an inflation-targeting paradigm, a rate cut can be justified when the projected inflation over the next six months is close to the upper limit of 6 per cent and the projected GDP growth is close to 8 per cent - considered the highest sustainable rate over the medium term. The fact that the decision was unanimous will raise doubts whether all relevant issues were debated and discussed by the MPC. One wonders if the MPC felt a need to distance itself from the legacy of Dr. Rajan.

It is likely that the MPC will go through an initial phase of 'learning by doing' as it evolves and matures as a professional policy-setter. But it is essential that it adopts a rule-based approach and methodology from the start itself and eschew too much discretion in order to find space for rate cuts for supporting growth.

Three-fold impact

As regards the impact of the rate cut, three issues loom large: credit growth, stressed assets/NPAs of banks and corporate investment. Extremely sluggish credit growth on the part of PSU banks to sectors other than retail borrowers is going to last for quite some time. And so long as the credit cost by way of provisioning for NPAs remains high, as is the case now, the likelihood of a reduction in borrowing cost in response to cuts in the policy rate will continue to be low.

Transmission of monetary policy will continue to remain sub-optimal till the estimated Rs.13.3 trillion (or Rs.13.3 lakh crore) of stressed assets/NPAs of banks are resolved. While RBI has done a good job in pushing banks to recognise their NPAs, it has been quiet on the lack of progress in the resolution of stressed assets/NPAs. While the government expects a good number of NPAs to become regular over the next few years, thereby making possible reversal of provisions made against them, there is little evidence of any progress on the ground in this regard.

Various schemes for debt resolution such as Corporate Debt Restructuring (CDR), Strategic Debt Restructuring (SDR) and the recent Scheme for Sustainable Structuring of Stressed Assets (S4A) have not had any noticeable impact so far. Illustratively, between 2009-10 and 2014-15, the total number of cases referred to CDR was 253 with an aggregate exposure of Rs.2.76 trillion (Rs 2.76 lakh crore), out of which only 5 cases involving Rs.16 billion (Rs.1,600 crore) have so far exited CDR successfully. SDR has been a non-starter and S4A has yet to take off.

The fundamental flaw in current debt resolution schemes is the lack of an enabling mechanism for infusion of fresh equity in the debtor companies. In most cases, fresh equity is unlikely without a repricing of the companies’ assets and liabilities that would lead to proper price discovery of its equity. This will entail an appropriate reduction in the companies’ debt owed to banks. Debt resolution by banks cannot happen if RBI relies only on its directives that are issued in a ‘command and control’ fashion. RBI and government must empower boards of PSU banks to take decisions on one-time settlements and debt write-off on commercial considerations alone, based on well-defined policies and the procedure to be formulated for this purpose.

Finally, the government should enable PSU banks to devise a solution to the following asymmetric incentives faced by in relation to stressed assets/NPAs: the downside of a loan becoming an NPA and unrecoverable is much less compared to the downside of a vigilance enquiry in respect of genuine debt resolution.

An unjustified rate cut has hurt the credibility of the newly formed MPC. It will do precious little with regard to problems associated with very high stressed assets/NPAs of banks, the resolution of which alone can spur credit growth and corporate investment that would lead to job creation for the youth of India.

Sivaprakasam Sivakumar is MD, Argonaut Global Capital LLC, U.S. and Himadri Bhattacharya is Senior Advisor, RisKontroller Global