Need to focus on multiple financial stability indicators

Market discourse around MPC meetings now focuses on estimating Consumer Price Inflation (CPI), and appropriate policy interest rate responses. In India, it is extremely difficult to estimate medium-term CPI, and to judge the impact of policy interest rate on CPI. There is merit in considering multiple financial stability indicators besides inflation, and responses beyond policy interest rates.

Macroeconomic indicators

First, with much of our socio-economic future dependent on job creation, we need a reliable measure of employment growth.

Second, the health of our financial system, across capital availability, stressed assets, and tepid credit offtake, needs addressing.

Third, the rupee has strengthened by over 10 per cent against the US dollar and Chinese Yuan Renminbi since 2016. Besides encouraging imports and hurting domestic industry, complacent unhedged FX exposures may also be increasing.

Fourth, state government finances and their possible impact on our overall fiscal situation bear watching.

Fifth, recent strength in our equity markets is backed more by increased domestic inflows, than by fundamental corporate results. This could at least in part be due to the reduction in post-tax returns from fixed deposits.

Lastly, the global context is an unusual mix of high event uncertainty, but low market volatility.

Possible policy response

First, operative short-term interest rates could come down by 50-75 bps. This would help reduce interest costs, encourage spending, and improve the health of the financial ecosystem. Lower short-term interest rates would also encourage hedging of FX exposures.

On the other hand, given uncertainty around the global context, our fiscal deficit, and the need for long-term deposit in the banking system, one would argue the need for stable or even higher long-term interest rates.

Policymakers have tools across liquidity, short-term operative rates, and bond open market operations (OMO), to achieve such a steeper yield curve.

Second, while ensuring adequate provision for non-performing assets, we should also address areas where capital and liquidity prescriptions are high compared to global standards. As examples, Liquidity Coverage Ratio (LCR) burden currently adds to bank Statutory Liquidity Ratio (SLR), and our Basel III Credit Value Adjustment (CVA) requirements are relatively high.

Third, we should guard against continued overvaluation of the rupee, particularly one fostered by an increase in unhedged currency exposures. Further, forward US dollar purchases by RBI increases forward premia, and incentivises increased unhedged exposures. We could instead consider using other instruments to sterilise liquidity.

Fourth, individual state government’s borrowing costs should be determined by their particular state of finances, rather than any notion of implicit backstop from RBI.

Lastly, there should be a review of the tax asymmetry between banking fixed deposits, debt mutual fund and equity investments. We do need incentives to encourage long-term customer deposits into banks, to allow the system to fund long-term investments better.

 

Conclusion

While the MPC is mandated to target inflation using policy interest rates, it does consider a whole set of other data. Public discourse would likewise do well to focus on financial stability as a whole, while considering a variety of tools, outside of policy rates.

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