In April, not too many bankers and bond dealers were expecting a rate cut, but Reserve Bank of India (RBI) governor D. Subbarao reduced both policy rates—the repo rate, at which RBI infuses liquidity into the system by lending to banks, and the reverse repo rate, at which it drains liquidity by borrowing from banks—by a quarter of a percentage point each. There were two reasons behind the cuts: First, the governor was not fully convinced that the economy had put the worst behind it; and second, he wanted insurance against an uncertain outlook.
In retrospect, that was not a bad move. The worst might be over for the economy, but uncertainties persist even now, as the central bank prepares to unveil its monetary policy statement on Tuesday.
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The fiscal deficit for the fiscal year to March 2010, which was estimated to be 5.5% of gross domestic product (GDP) in the February interim budget, has widened to 6.8%, and the government will borrow Rs4.51 trillion from the market, Rs89,000 crore more than its earlier projection of Rs3.62 trillion. While managing such a huge market borrowing programme will be the central bank’s biggest challenge this year, the other worries are a lack of clarity over the outlook for the monsoon and sluggish growth in bank credit. After four consecutive years of plentiful rain, the monsoon began on a very weak note and in June was some 48% deficient, the driest in at least 15 years. Banks’ year-on-year credit growth at 16.3% in June was also the lowest in many years. By the end of the first quarter of the current fiscal, credit growth was just 0.8%.
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Even though the outlook for economic growth has improved since the announcement of RBI’s annual monetary policy in April, these factors will discourage Subbarao from withdrawing any of the monetary accommodation that the Indian central bank has extended since September to fight a credit crunch and bolster slowing economic growth.
Falling inflation is another factor that will restrain him from raising interest rates. The benchmark wholesale price-based inflation rate declined for six weeks in a row between June and mid-July. In the first week of June, the inflation index declined 1.61% from a year earlier, setting the trend, and for the week ended 11 July, the fall was marginally lower, 1.17%. But the trend may be reversed sooner than later on rising oil and commodity prices and the likelihood of a deficient monsoon pushing up food prices. In its annual policy statement in April, RBI projected the inflation rate at 4% by year-end, but many analysts predict it will be higher by the time the fiscal year ends in March. The central bank is likely to revise its inflation projection during the course of the year, and raise its policy rate next year.
After the April rate cut, the repo rate has come down to 4.75%, from 9% in September, and the reverse repo rate to 3.25%, from 6%. The repo rate acts as a policy rate when the banking system is dry and RBI needs to infuse liquidity into the system, but the reverse repo rate becomes the policy rate when the system is flush with liquidity and RBI absorbs this liquidity. In September, there was no liquidity in the system. Now, on average, banks are parking about Rs1.3 trillion with RBI daily.
Because the policy rate is no longer the repo rate but the reverse repo, the cut has been deeper; effectively the policy rate has been pared from 9% in September to 3.25%.
During this time, banks’ cash reserve ratio, or the portion of deposits that banks need to keep with RBI, has been cut from 9% to 5%, releasing Rs1.6 trillion into the banking system. Overall, since September, through various measures, RBI has generated Rs3.9 trillion of liquidity, around 7% of the country’s GDP. This, along with the government’s stimulus packages, staggered over months and accounting for 3% of India’s Rs54 trillion GDP, have helped the economy regain momentum, with demand for automobiles and mortgages resurfacing and industrial growth picking up although exports continue to decline.
Subbarao is unlikely to be in a hurry to drain liquidity from the system. This is needed to see the government’s massive borrowing programme through. In addition to bridging the Centre’s Rs4.51 trillion deficit, the banking system will have to take care of Rs1.6 trillion worth of borrowing by state governments during the year. Even if the Centre is able to stick to its borrowing estimate, banks will be left with little money to lend to others. This will put pressure on interest rates.
RBI, the government’s investment banker, is planning to manage the programme by buying bonds from the market through its open market operations and transferring intervention bonds from its kitty to the government. The intervention bonds were floated between 2004 and 2007 under the so-called Market Stabilization Scheme, or MSS, to drain the excess liquidity created because of RBI’s intervention in the foreign exchange market. RBI was buying dollars to check the runaway appreciation of the rupee at the time because a strong local currency hurts exporters by reducing the rupee equivalent of their foreign exchange earnings.
For every dollar that RBI bought, an equivalent amount of rupees flowed into the system and the MSS bonds sucked out the excess money.
Before raising its policy rate, RBI can use both tools to tighten liquidity in the system when it wants to withdraw its accommodative policy at the first signs of inflation creeping up. For the time being, it needs to convince banks to lend to firms and individuals and signal that low rates and liquidity are here to stay until the economy is firmly back on the path of higher growth.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email comments to email@example.com
Graphics by Sandeep Bhatnagar / Mint