The Reserve Bank of India, or RBI, on Tuesday signalled an exit from its expansionary monetary policy, ahead of other Asian central banks. RBI governor D. Subbarao has refrained from any hike in the policy rate and the cash reserve that commercial banks are required to keep with it, but shut all refinance windows that were opened for various sectors after the collapse of US investment bank Lehman Brothers Holdings Inc. in September 2008. It’s now a matter of months before the central bank goes for a hike in banks’ cash reserve and/or a hike in policy rates. And this can happen even earlier than its next review of monetary policy in January.
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The central bank’s urgency to tighten its policy is evident from the dramatic shift in its stance—from supporting growth to managing inflation. In fact, both price stability and financial stability now top RBI’s priority list, in that order, ahead of growth.
Till recently, it was giving an equal importance to all three but this time around, the policy document makes no bones about the fact that its “fundamental commitment” is to “price stability” and it will take measures as warranted by the evolving macroeconomic conditions “swiftly and effectively”. The rise in RBI’s year-end inflation estimate from 5% to 6.5% “with an upside bias” gives credence to the belief that a hike in rate and tightening of liquidity is imminent.
Indeed, some of RBI’s actions are rather academic at this point. They do not match the governor’s tough talk and won’t have a huge impact, but they are of enormous symbolic value. They signal the withdrawal of accommodation, a precursor to actual tight money policy that will raise the borrowing cost for firms and individual consumers and stamp out liquidity that stokes inflation.
To start with, Subbarao has raised the floor for banks’ holding of government bonds from 24% to 25% of their deposits and closed most of the special refinance facilities that were opened in the wake of the global credit crunch. Theoretically, a 1 percentage point hike in banks’ government bond holdings means withdrawal of liquidity from the system and less money in banks’ kitty for giving loans, but since they have already invested 27.6% of their deposits in government bonds, the hike will not make any material difference right now.
Similarly, the withdrawal of refinance facilities for non-banks, housing finance firms, mutual funds and exporters and closure of the window for swapping banks’ foreign exchange liabilities will hardly make any difference, as there haven’t been too many takers for such facilities with around Rs1.2 trillion excess liquidity sloshing the system. These windows were to close in March. But their early close is a signal of the reversal of stance—a year after RBI opened all taps to generate liquidity and prop up a slowing economy.
Between October and April, RBI brought down its repurchase (repo) rate or the rate at which it infuses liquidity in the system by 4.25 percentage points, from 9% to 4.75%; reverse repo rate or the rate at which it sucks out liquidity from the system by 1.75 percentage points, from 5% to 3.25%; and banks’ cash reserve ratio, or CRR—the portion of deposits that banks need to keep with RBI— by 4 percentage points from 9% to 5%. Collectively, the CRR cut and new refinance windows infused Rs5.6 trillion into the financial system. All these measures have improved the prospects of the economy, which RBI feels will grow at 6% or even at a slightly higher rate. And hence the shift in focus, from managing the crisis to managing recovery.
In fact, apart from raising SLR to its 2008 level, RBI has also quietly raised banks CRR through the back door. While CRR continues to remain 5%, banks’ borrowing from the money market, which was never taken into account while calculating their CRR obligation, will now be considered. The daily average of such borrowings is now around Rs60,000 crore. This means banks will have to keep an additional Rs3,000 crore with RBI from the third week of November. Such an action will not have an immediate impact on the banking system but help banks prepare for the next stage of action. Similarly, a hike in provisioning requirements for loans given to commercial real estate developers and provisions for all stressed assets are prudential measures to strengthen their balance sheets, but behind such moves are in play RBI’s apprehensions on incipient signs of asset bubbles. In fact, by raising the provisions for real estate loans, RBI has joined authorities in other Asian countries such as Korea, Singapore and Hong Kong in cooling the property market and preventing any bubble being formed. Prices of real estate in India have almost returned to their peaks seen in late 2007 and early 2008 before the crash.
In early October, when Subbarao announced that he would need “to exit from the present excessively accommodative monetary and fiscal policies” but wondered loudly “when and how” he should exit, there was strong opposition from the government. Finance secretary Ashok Chawla, deputy chairman of Planning Commission Montek Singh Ahluwalia and chairman of the Prime Minister’s economic advisory council C. Rangarajan—three wise men who form the government’s economic think tank and provide valuable inputs to the making of the monetary policy —all advised him to wait for the right time for exit. The governor, however, has stuck to his guns.
In times of crisis, it is relatively easy for the central bank and the finance ministry to coordinate, but cracks are bound to surface in good times. Hiking policy rates will not be as easy as ending the easy money regime, even though Subbarao is convinced that it has to be done sooner than many others say.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to email@example.com
Graphics by Ahmed Raza Khan / Mint