Bank stocks have been rising on speculation that a possible US Federal Reserve rate cut this week may add pressure on the Reserve Bank of India (RBI) governor Yaga Venugopal Reddy to ease local rates. The Federal Open Market Committee, the monetary policymaking body of the Fed, will meet on Tuesday-Wednesday and make public its move a day after Reddy announces his mid-term review of the monetary policy.
In September, the Fed announced an aggressive 50-basis points cut in the Fed funds rate, its first in more than four years, to 4.75%.
Theoretically, Reddy will be under pressure to change the stance of the monetary policy and adopt a soft approach as a wider difference between Indian rates and that of the US would encourage more capital flows here, leading to appreciation of the rupee and reducing the value of exports in rupee terms. Along with bank stocks, the bond market, too, has started punting on a possible rate cut. The 10-year bond yield has dropped about 9 paise to 7.81% last week.
One thing is very clear at this point: Interest rates in India have peaked and from here RBI can only cut rates, not raise them. Since January 2006, Reddy has raised the repo rate or the rate at which RBI injects liquidity in the system six times, by 25-basis points each, to 7.75%. The reverse repo rate or the rate at which the Indian central bank absorbs liquidity has remained at 6% since July 2006, and this is the policy rate now. Reddy has also raised banks’ cash reserve kept with RBI by 2 percentage points to 7% between December 2006 and July 2007, stamping out about Rs56,000 crore from the financial system.
The results of his tight money policy are evident. The year-on-year credit growth has come down to 23.3%, from more than 30% for two years in a row. Inflation rate, too, has dropped to 3.07%, well within RBI’s comfort zone, and sharply down from its February level of 6.63%.
Surfeit of liquidity is the only problem in an otherwise benign macroeconomic environment. RBI has been absorbing on an average about Rs40,000 crore liquidity through its reverse repo window every day in October. The liquidity is the result of its intervention in the foreign exchange market. RBI is distinctly uncomfortable with the rise of the rupee as that erodes the competitiveness of the currency. Since the beginning of the year, India’s foreign currency assets have risen by close to $61.4 billion (Rs2.4 trillion). With every dollar RBI buys, an equivalent amount of rupees finds its way into the financial system. This means the RBI intervention has added about Rs2.4 trillion to domestic liquidity this fiscal.
It could have been even more but for the sell-buy swaps that RBI has recently started conducting in the foreign exchange market to drain liquidity. The sell-buy swaps postpone the creation of rupee liquidity immediately after RBI’s intervention in the foreign exchange market. The swap involves selling dollars with a simultaneous agreement to buy them back at a future date at a specified price. This is nothing but a forward contract. While selling dollars back into the system, RBI books a contract with the buyers to buy the dollars back at a specified price, at a future date. When the time comes to buy back these dollars, RBI can always review the liquidity situation and either roll over such swaps or convert the dollars into local currency. Globally, central banks use such swaps to postpone liquidity creation generated by capital inflows.
While sell-buy swaps are postponing the creation of rupee liquidity, the market stabilization scheme (MSS) of the government has been absorbing liquidity. The corpus of the scheme has been raised from Rs1.1 trillion to Rs2 trillion in last three months, and about Rs1.77 trillion of this has been used. This means another Rs23,000 crore can be absorbed by MSS and the government can always increase the corpus of the scheme to drain more liquidity. If that is done, banks can be spared from a hike in their cash reserve ratio.
So, what should Reddy do? One way of approaching his task could be doing nothing and maintaining the status quo for the time being. Some analysts feel there is a slowdown in credit growth and the inflation rate is modest, and if Reddy does not go for a rate cut at this point, he may have to regret it later. Indeed, banks are finding it difficult to push retail loans even after paring their rates to attract new customers. However, there is no distinct sign of a slowdown as yet. Traditionally, bank credit growth gathers momentum in the second half of the year and Reddy can always wait till January to take stock of the scene at the quarterly review of monetary policy. If the situation demands, he can even go for a rate cut before January.
By that time, the trajectory of the US Fed action as well as the impact of Indian capital market regulator’s stance on participatory notes will be well known. Low wholesale price-based inflation rate is indeed an incentive to cut interest rates but the consumer price-based inflation—both for industrial worker as well as rural labour—continues to be high and nobody seems to know the peak of oil prices. Ideally, Reddy should abstain from any monetary measures. Still if he wants to be seen as acting, he can cut the repo rate by 25 basis points to 7.50%. That will be a mere symbolic act as the real policy rate in Indian context is the 6% reverse repo rate. Commercial banks’ deposit and lending rates have already started pricing in the symbolic rate cut.
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