Urjit Patel on SLR and Indian monetary policy

While TCA Srinivasa Raghavan tweeted on Sunday on a 2012 paper by Dr. Urjit Patel, I saw in my in-tray (electronic) that I had downloaded a working paper co-authored by him with Amartya Lahiri. This was the first working paper of the year from RBI.

It is titled, ‘Challenges of Effective Monetary Policy in Emerging Economies ‘. (Ref: WPS (DEPR): 01 / 2016)

Their main conclusion:

In the presence of a binding SLR, he and his co-author argue that a reduction in interest rates reduces rates on deposits and, to the extent, deposit outflows happen (or inflows slow), credit to the private sector actually drops (SLR is binding and hence, loans to the government do not shrink) and that leads to higher interest rates! In other words, policy easing is contractionary!

Secondary conclusion:

The authors say that when there are distortions like binding SLRs, conventional monetary policy results are obtained by changing the SLR itself rather than interest rates!

Lower SLR = monetary expansion
Higher SLR = monetary tightening (page 34)

Policy distortions:

The authors are critical of loan targets given for the agricultural sector between 2004 and 2007 and how they distorted allocation of credit, along with the interest rate subvention for loans to agricultural sector (topped up by State governments) and capped by loan waiver of 2008! In effect, the UPA government did all the wrong things – interfered with quantity, price and then topped it up with moral hazard! (Page 11)

Fiscal dominance is always more likely than monetary dominance since central banks are in the business of brinkmanship (quote from Bernanke) due to the likely fallout on the banking sector. (page 9)

The authors do not hesitate to point to administered interest rates as another policy distortion that undermines monetary policy. (Page 10-11).

Their model is not that easy to understand in one casual reading. Plus, some amount of tightening of notations to ensure consistency and avoid confusion is, perhaps, needed.

One interesting/disturbing fact of PSU bank behaviour:

Between 2009 and 2014, public sector banks tended to hold government bonds well in excess of SLR requirements. Some amount of excess is reasonable given the access it gives them to funds under MSF (at 1% above the repo rate). But, their holdings were higher, even after adjusting for it.

The authors are very clear on the consequence of this:

This, of course, is costly to the tax payer as the banks are potentially losing profits that they could make while they are also contributing to a liquidity squeeze in the economy. A third deleterious e¤ect of this banking strategy is that the lower return on bank assets tends to get passed on to bank depositors as lower deposit rates and consequently tends to lower saving rates as well. In a developing economy that is starved for investable funds, this is very damaging. (page 32).

This underscores the urgency of addressing the Banking Sector (esp. PSU banks) NPA problem in India. It is causing so many other distortions in the economy.

Their conclusions as to the implications of their paper for central banks are interesting:

For the central bank, the tasks ahead are two-fold. First, perhaps re-balance the reform agenda from high pro…le subjects such as legislative amendments, like a monetary policy framework and associated institutional changes, to addressing policy-induced distortions that undermine monetary policy e¢ cacy and transmission.

Second, address the challenge of multiple roles/objectives and limited instruments.

Here are our questions:

Where does this leave RBI under him on interest rate changes? No cut at all?

What levers does the RBI have on fiscal policy, if any, at all?

Is the new monetary policy framework redundant in the light of the binding SLR? Does it really matter that India has such a framework now?

How to present this paper to the government (and national and regional political parties) in a non-technical manner such that they understand the situation in which policy is being made and rendered ineffective?

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