Understanding Central Banking and Its Challenges
Central banking is a complex field that combines both art and science. It requires central bankers to make decisions based on past data, which can be challenging, especially when it comes to predicting future outcomes. They have to drive ahead while keeping an eye on the rear-view mirror, analyzing past data to shape monetary policy for the future.
The Reserve Bank of India’s Policy Shift
In April, the Reserve Bank of India (RBI) made a significant shift in its policy stance, moving from inflation control to growth support. This decision was made in response to a flattening rise in the cost of living. The RBI’s monetary policy committee, led by Governor Sanjay Malhotra, took bold steps to cut benchmark interest rates by a full percentage point and ease liquidity. The goal was to generate credit demand in India Inc and encourage banks to offer cheaper loans, which would stimulate economic growth.
The Overlooked Challenge: Stagnant Consumption Demand
However, this drive seems to have overlooked a crucial aspect: stagnant consumption demand. This has resulted in dampened capacity utilization of industry, which in turn has reduced the need for credit. Despite excess money in the banking system, credit demand remains sluggish. The RBI has been forced to absorb liquidity every week, with a significant amount of ₹14.2 trillion absorbed in just seven days from July 3 to July 10.
Indicators of Excess Liquidity
Another indicator of excess liquidity is the category of ‘Other Deposits’ in the RBI’s list of liabilities, which includes reverse repo operations. This category has seen a 43% increase in the 12 months ended July 11. Weak demand for credit and the need for lenders to earn from the available liquidity may have led to desperation. Non-bank lenders have started targeting retail borrowers again, offering unsecured loans to meet everyday consumption needs.
Risks Associated with Excess Liquidity
If history is any guide, a surge in unsecured loans can pose a significant risk. Borrowers who take out multiple loans may struggle to repay them, and any stress event can trigger a cascade of defaults. Excess liquidity can also lead to unintended consequences, such as banks becoming less inclined to solicit deposits from savers. This could drive more savings towards high-risk-high-return assets, potentially through speculative platforms in equity markets.
Potential Consequences and Lessons from the Past
The economy may witness a replay of the near-crisis that occurred two to three years ago, characterized by a spike in unsecured retail lending for consumption and high speculation in equity derivatives. Former RBI Governor Shaktikanta Das had addressed this issue by tightening prudential norms, but Governor Malhotra relaxed these rules soon after taking office. Another potential consequence of surplus systemic liquidity is inflation, which can occur when credit demand from businesses is weak, and the money pumped out fuels demand for goods and services that producers cannot meet.
Conclusion
In conclusion, the current cocktail of listless credit demand and profuse liquidity poses significant risks to the economy. The June policy meeting’s dissent note advocating “cautious progress in policy easing” has more resonance now than ever before. Governor Malhotra’s concession that a pick-up in credit demand will ultimately depend on macro-economic factors highlights the complexity of the issue. The RBI’s rate cuts and liquidity infusion are necessary but not sufficient conditions for stimulating economic growth. As such, it is essential to exercise caution and consider the potential consequences of excess liquidity to avoid repeats of past crises.
