The inflation rate is veering around 4.4%, well within the Reserve Bank of India’s (RBI) comfort zone, and the banking sector’s credit growth has come down from over 30% for three years in a row to less than 25% now. In cricketing parlance, this is a dream pitch to bat on for any central banker. Yet, Yaga Venugpal Reddy will probably find it one of the most difficult phases in his four-year career as RBI governor when he announces the quarterly review of monetary policy on 31 July. The joker in the pack is liquidity in the system that has been driving down overnight interest rates to below 0.5%.
Where is the liquidity coming from? There are two sources: first, increasing spending by the Union government, and the second, RBI’s heavy intervention in the foreign exchange market. In the first two months of fiscal year 2007-08, government expenditure went up by Rs90,750 crore and the trend continued in June. However, this is not a new phenomenon. Traditionally, in the beginning of every fiscal year, government spending rises, adding to liquidity and as the year progresses, the spending subsides. However, RBI intervention in the foreign exchange market seems to be here to stay unless the dollar shrugs off its global weakness.
RBI is uncomfortable with the rupee rising beyond 40 to a dollar as that leads to loss of competitiveness in the currency. The exporters’ lobby is already up in arms as with every paisa of rupee appreciation against the dollar, the income of exporters who earn in dollars goes down in rupee terms. The local currency has appreciated close to 10% since the beginning of the year. Had RBI not been in the market buying dollars, it would have risen even more. In the past two months alone, it has bought about $14 billion from the market. With every dollar RBI buys, an equivalent amount of rupees finds its way into the financial system. This means the intervention has added about Rs56,000 crore to domestic liquidity.
Where will the money go? With the credit growth slowing down, banks can park the surplus liquidity with RBI at 6% interest. However, the central bank has virtually blocked this channel by limiting its absorption of excess liquidity at Rs3,000 crore. So, unable to enter the RBI window, the daily wave of liquidity—at times over Rs50,000 crore—rushes to the overnight market, driving down the rates to abnormally low levels. Reddy has been helplessly watching the surfeit of liquidity making the central bank’s interest rate corridor meaningless. Ideally, the overnight rate should move between 6% (the rate at which RBI absorbs liquidity) and 7.75% (the rate at which RBI injects liquidity). If this continues, banks will be encouraged to ride on easy liquidity and lend more. Once this happens, the inflation rate will rise and we will be back to square one.
So, what could be Reddy’s game plan? If he does not do anything, it will be interpreted as a clear signal of an easy money policy and banks will start lending aggressively. The 10-year bond yield, which has come down from a high of 8.4% in June to 7.8% now, will crash and the entire yield curve of government bonds will be distorted. One option before him is to lift the cap of Rs3,000 crore and absorb the excess liquidity fully. In fact, bankers and bond dealers have been demanding this. Once this is done, the overnight rate will go up. But, on the flip side, it will virtually amount to a rate cut. The policy rate will come down sharply from 7.75% to 6% without any formal rate cut. RBI could, of course, adopt a tier approach and start absorbing liquidity at various levels—say, Rs3,000 crore at 6% and next Rs10,000 crore at 5.5% and so on. But even this could be interpreted as a rate cut and give the bankers comfort that the liquidity is here to stay.
Indeed, liquidity is here to stay, at least in the medium term, and Reddy seems to be trapped in a policy of his own making. If he does not want banks to lend more, the liquidity has to be sterilized and sterilization has a cost. The question is: who will bear this cost? There are three ways it can be sterilized. First, RBI can lift the cap of Rs3,000 crore and absorb it. In this case, RBI has to pay 6% interest. Second, the government can issue more bonds under the market stabilization scheme, created in 2004 to absorb excess liquidity. Currently, it has a limit of Rs1.1 trillion and Rs85,000 crore of this has been used. In this case, the government is bearing the cost of sterilization. Finally, banks can also be made to bear the cost if RBI raises their cash reserve ratio (CRR). Currently, banks keep 6.5% of their deposits with RBI and do not get any interest on that. A 0.5% hike in CRR will stamp out about Rs15,000 crore from the system.
At this juncture, RBI’s monetary policy is inseparable from its currency policy. Since there is unlikely to be any change in its interventionist approach in the foreign exchange market, RBI must find ways to absorb excess liquidity from the system. That is, if it wants to discourage banks from going back to aggressive lending. Removal of the cap on RBI’s daily absorption of liquidity and a hike in CRR should be the ideal combination to deal with the situation. In due course, the government should also issue more bonds under the special scheme to suck out liquidity. If Reddy prefers to wait and watch till his next quarterly review in October, his inaction will be the biggest action, marking a clear shift from a tight monetary policy to an accommodative one.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai Bureau Chief of Mint. Please email comments to firstname.lastname@example.org