I am fairly convinced that Reserve Bank of India (RBI) governor D. Subbarao will increase banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks are required to keep with the central bank, by at least half a percentage point in the 29 January review of monetary policy. This will probably be implemented in two stages and drain out about Rs22,000 crore of liquidity from the system.
Subbarao may refrain from raising interest rates even though many members of the technical advisory committee (TAC) on monetary policy at RBI, I am told, are rooting for an increase to rein in inflationary expectations. Headed by Subbarao, this committee has the deputy governors as well as Ashok S. Ganguly and Y.H. Malegam (both from RBI’s central board) as its members, besides experts such as D.M. Nachane, Shankar Acharya, Samir Kumar Barua, P.J. Nayak and A. Vasudevan.
The wholesale price-based inflation was 7.31% in December and many analysts believe that it may touch 10% in the next few months, much higher than the Indian central bank’s fiscal year-end estimate of 6.5% with an “upward bias”. Indeed, inflation is largely driven by high food prices, a supply-side phenomenon, and monetary tightening cannot do much to tame this, but the TAC members as well as many economists and analysts are seeing signs of rising demand in some pockets of the economy. In fact, demand-driven core inflation, too, is inching up. Besides, bank credit that had been growing at a tardy pace until recently has started picking up. The year-on-year bank credit growth is now 13.7%.
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Industrial production has started growing at a double-digit rate.
Rarely have we seen so much divergence of opinion among the key government officials on the direction of monetary policy. Both Kaushik Basu, chief economic adviser in the ministry of finance, and Planning Commission deputy chairman Montek Singh Ahluwalia have strongly argued against any monetary tightening because that would affect growth and employment while C. Rangarajan, chairman of the Prime Minister’s economic advisory council and a former governor of RBI, is in favour of an increase in banks’ CRR as absorption of excess cash from the banking system can ease inflationary pressure.
If indeed Subbarao bites the bullet this week and tightens liquidity, India will be the first among Asian economies to meaningfully reverse its policy stance. The Australian central bank has raised its policy rate thrice in the past few months; China has raised its CRR to cool the world’s fastest growing major economy as high credit growth threatens to stoke inflation and create asset bubbles.
Balancing act: RBI governor D. Subbarao. The central bank signalled an exit from its expansionary monetary policy in October, but many of its actions at that time were academic in nature. Abhijit Bhatlekar/Mint
RBI signalled an exit from its expansionary monetary policy in October, but many of its actions at that time were academic in nature. It shut all refinance windows that had been opened for various sectors in the wake of the global credit crunch and its focus shifted from supporting growth to managing inflation. The floor for banks’ holding of government bonds was also raised from 24% to 25% of their deposits.
A 1 percentage point hike in government bond holdings means withdrawal of liquidity from the system and less money in the banks’ kitty for giving loans, but because banks had already invested about 28% of their deposits in government bonds, the increase did not have any impact on liquidity. Similarly, the withdrawal of refinance facilities for non-banking finance companies, housing finance firms, mutual funds and exporters and the closure of the window for swapping banks’ foreign exchange liabilities hardly made any difference. With so much liquidity sloshing through the system, nobody needed such facilities. Even now, banks are parking around Rs75,000 crore daily with RBI.
Between October 2008 and April 2009, RBI had 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%. The reverse repo rate, or the rate at which it sucks out liquidity from the system, was lowered to 3.25% and banks’ CRR by 4 percentage points from 9% to 5%. The combination of refinance windows and CRR cut infused Rs5.6 trillion into the financial system.
In its half-year review of monetary policy in October, RBI also raised provisioning requirements for loans given to commercial real estate developers and provisions for all stressed assets, apprehending incipient signs of asset bubbles. These steps and the withdrawal of accommodation were a precursor to a tight money policy and this will happen now. Even if the Indian central bank leaves the rates untouched for the time being and prefers to wait for the February Union Budget to get a sense of the government borrowing programme for fiscal 2011, it will definitely raise CRR to dampen inflationary expectations. One may ask what purpose it will serve, especially when RBI’s repo window too can absorb liquidity. There are three ways of liquidity absorption.
While the repo window absorbs liquidity daily and the cost is borne by RBI, both CRR and market stabilization bonds are permanent liquidity absorption tools. In the case of CRR, the banks bear the cost as they do not earn any interest on the cash that is kept with RBI. In the case of market stabilization bonds, the government bears the cost as it pays interest on this paper. If RBI does not act now, it will have to resort to a larger dose of CRR and rate hikes later. The good news is that a hike in CRR at this point may not immediately push up the borrowing costs for firms and individual consumers as banks will continue to have appropriate liquidity.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Email your comments to bankerstrust@ livemint.com