In the past one month, since the Wall Street icon Lehman Brothers Holdings Inc. filed for bankruptcy, plunging the global financial system into the deepest-ever crisis since the Great Depression of the 1930s, the Reserve Bank of India (RBI) has cut its cash reserve ratio (CRR), or the money that banks need to keep with the Indian central bank, by 250 basis points, releasing Rs1 trillion.
It has also temporarily allowed commercial banks to hold 23.5% of their deposits in government bonds, instead of 25%, required under the banking law, to generate liquidity. Besides, the interest rates on non-resident Indian (NRI) deposits have gone up by 100 basis points to attract funds from overseas at a time when foreign institutional investors (FIIs) are pulling out of Indian equities to send money home.
What else can RBI do when it unveils the mid-term review of monetary policy on 24 October?
The review has lost its relevance as RBI has been announcing monetary measures almost every day, responding to the evolving circumstances. Besides, at this critical juncture, RBI does not seem to have an independent voice and all policy measures are a concerted action of the banking regulator, the capital market regulator as well as the ministry of finance. In fact, ever since D. Subbarao has become RBI governor, the former finance secretary of India seems to be spending more time in North Block in Delhi with finance minister P. Chidambaram than at RBI headquarters in Mumbai. There’s nothing wrong with this as the finance ministry and RBI cannot afford to have divergent views in this hour of crisis. Federal Reserve chairman Ben Bernanke, too, spends more time these days with treasury secretary Henry Paulson than with other members of the Federal Open Markets Committee, Fed’s policymaking body.
Indeed, the Rs1 trillion fund infusion has brought back a semblance of order in the Indian financial system. The rate of overnight call money market, where banks borrow from each other to tide over their temporary asset-liability mismatches, dropped to 7% last week after rising to 22% the week before. Banks’ daily borrowing from RBI’s repurchase, or repo window, dropped to an average of less than Rs3,000 crore in past two days, from a daily average of Rs80,000 crore in the first fortnight of October.
What is more, at least some banks have excess liquidity and on average they parked about Rs6,000 crore with RBI’s reverse-repo window in the last two days of the past week. The central bank infuses liquidity in the system through its repo window at 9% and mops up excess liquidity through its reverse-repo window at 6%.
Unlike the US Federal Reserve and most other central banks across the globe, RBI has two policy rates and the gap between the two rates forms a corridor within which the cost of overnight money should move. In a liquidity-surplus situation, the effective policy rate is 6%. Similarly, in a liquidity-starved situation, 9% is the policy rate. However, the overnight rate went beyond 9% and stayed there for days this month because the liquidity crunch was severe and banks did not have enough excess government bonds in their portfolio which they require as collaterals while borrowing from the RBI window.
Under the law, Indian banks are required to invest 25% of their deposits in government bonds known as statutory liquidity ratio (SLR) and any excess bond holdings can be used to borrow from RBI. The SLR level has recently been brought to 23.5%, as a temporary measure, to help banks borrow for themselves as well as mutual funds that have been seeing huge redemptions.
After the CRR cut, the banking system now has about Rs10,000 crore excess liquidity but banks are nervous and have virtually stopped giving loans to corporations as well as individuals as they are not sure how long will this liquidity last. The biggest challenge before RBI is to address the risk aversion of banks and restore confidence in the system.
Banks will start lending only when they are sure there won’t be any liquidity problem tomorrow and RBI must allow this comfort for them. The current liquidity will not last unless the central bank stops selling dollars in the foreign exchange market. In the week ended 10 October, RBI sold close to $10 billion, bringing down the country’s foreign exchange reserve to $274 billion. The reserve was more than $316 billion in May. The rupee dropped to its six-year low of 48.88 to a dollar on Friday, losing close to 20% this year and surrendering its last five year’s gain against the greenback.
RBI is likely to continue to sell dollar to protect the fall of the local currency and for every dollar it sells an equivalent amount of rupee is sucked out from the system. So, RBI needs to convince the market that there will be more CRR cuts to make money available for the system.
It also needs to cut SLR if it wants banks to lend. By allowing banks to keep less SLR for the time being, RBI has enabled them to borrow money to take care of their temporary asset-liability mismatches, but they cannot use this money to lend. But if SLR is cut, banks will have more money at their disposal for loans.
Finally, RBI needs to cut the policy rate. Between April and August, the rate was raised by 125 basis points to rein in the rising inflation. The wholesale price-based inflation is still high but the trend will reverse soon with global commodity prices coming down. RBI should not worry about inflation. The real worry is growth and financial stability.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to email@example.com
Also read Tamal Bandyopadhyay’s earlier columns