Why did Chetan Ghate, one of the six members of the monetary policy committee (MPC) panel, voted for a 25 bps rate cut when all other members went for 40 bps? According to the minutes of the MPC meeting of May 20-22, out of the six members of the panel, only Ghate voted for a quarter percentage point rate cut.
The MPC ultimately finally settled for a 40 bps rate cut as part of the monetary policy measures to combat the COVID-19 impact, hoping that it would help banks lend more to companies and individuals, and thus kickstart the economy. But Ghate had a different opinion.
Ghate’s explanation to his decision throws light to a deeper problem that has been repeatedly asked in the context of arguments that suggest that rate cuts can play a big role in the economic revival. That problem is the lack of monetary policy transmission in the banking system. RBI tells banks to cut rates but banks often ignore the cues.
Ghate is spot on:
“For rate cuts to work, banks have to lend. Despite the large number of steps taken to improve the liquidity and functioning of credit markets, as of April 24 (the most recent data available), non-food credit growth on a y-o-y basis was at 6.5 per cent on May 8, 2020, lower than 7.2 percent on April 10, 2020,” Ghate said.
The RBI, since its first press meet on March 27, has announced measures to the tune of Rs 8 lakh crore. There have been general liquidity easing measures and sector-specific liquidity operations alongwith two rounds of rate cuts amounting to 115 bps. Despite these measures, bank credit growth has not picked up.
The demand is scenario is making liquidity transmission ineffective from banks to borrowers. With no economic recovery in sight, companies and individual consumers do not have the confidence to borrow more. In the absence of business revival, this could add to their existing liabilities and push into the trap of overindebtedness. RBI’s recent consumer confidence surveys point to a deep fall in consumer confidence.
So what’s the relevance of rate cuts?
“Rate cuts should be seen as part other measures that have already been taken with respect to liquidity policy, social insurance policy, and fiscal policy in dealing with the crisis. Since the last review, a comprehensive fiscal stimulus has been announced, amounting to about 10 per cent of GDP. The “Keynesian component” of the stimulus, i.e., the part that increases discretionary spending via fiscal policy is however around 1 percent of GDP,” Ghate noted.
Ghate also argued that big rate cuts should be saved for when the economy starts reviving, and not when we are in a lock-down. “Rate cuts, assuming that there is transmission and banks lend, works most effectively when the economy is on the upside. The MPC should keep some gunpowder dry,” Ghate said.
Further, Ghate says, the reverse repo rate has been cut thrice in succession to 3.35 percent. The idea behind the asymmetric cuts is to use the LAF corridor as an instrument of monetary policy, this is intended at disincentivising banks to park money in the reverse repo window. This has made reverse repo the effective policy rate.
Ghate concludes with a warning note. “I worry that the current quantum of liquidity will be difficult to unwind when things return back to normal.”
Source:- moneycontrol.com