As widely expected, the central bank left its key policy rates unchanged in its third quarter review of monetary policy on Friday, but raised the cash reserve ratio (CRR), or the portion of deposits that banks need to keep with the Reserve Bank of India (RBI), by three-fourths of a percentage point, a quarter percentage point higher than what the market had expected.
In two phases spread over February, this will drain out Rs36,000 crore from the financial system and guard against excess liquidity feeding into inflation in the world’s second fastest growing economy.
Also Read Tamal Bandyopadhyay’s earlier columns
In mid-January, China raised banks’ CRR to cool the world’s fastest growing major economy as a credit boom threatens to stoke inflation and create asset bubbles. In India, the credit offtake is still tardy, but the inflation has been rising and RBI fears that pickup in demand could exacerbate inflationary pressures. It has raised its fiscal year-end inflation estimate from 6.5% to 8.5% and growth in India’s gross domestic product from 6% to 7.5%. Still, the central bank refrained from any rate hike as it has found that the economic recovery is “unbalanced” and yet to become “sufficiently broad-based”.
The yield on the benchmark 10-year bond rose by 5 basis points (bps) immediately after RBI put up the policy document on its website and television channels flashed the news, but by the end of the day, there was hardly any change in yield from the previous day’s close. The knee-jerk reaction was seen in equity markets too. The Bombay Stock Exchange’s benchmark index, Sensex, plunged 318 points or 2% immediately, but recovered as the day progressed to end in the green, up 0.31%. The exchange’s banking sector index rose by 3%. Along with banks, the indices of real estate and auto stocks, extremely sensitive to interest rates, rose by 2.6% and 0.37%, respectively.
In a rising interest rate scenario, banks’ profitability is hit as the value of their bond portfolio depreciates and they need to set aside a portion of their profits to provide for it. Similarly, demand for real estate and automobiles goes down as their cost goes up for consumers who take loans to buy such products.
More potent tool
Indeed, both the bond and equity markets heaved a sigh of relief in the absence of any rate hike, but this may not last for long.
As a policy measure, a 75 bps hike in CRR is a more potent tool than a combination of a 50 bps hike in CRR and a 25 bps hike in policy rate, which has remained unchanged at 3.25% since April 2009. One basis point is one- hundredth of a percentage point. At this juncture, more than the policy rate, liquidity is playing a critical role as it is driving the markets. The CRR hike will suck out Rs36,000 crore, roughly 50% of the excess liquidity that is sloshing the system. In the second half of March, there won’t be much of money left on account of advance tax outflow. Indian firms pay corporate tax every quarter-end on their estimated profits.
So, if banks’ loan growth gathers pace, the system will run dry in March and banks will have to borrow from RBI’s repo window, paying 4.75%. Currently, banks are parking excess money at RBI’s reverse repo window and earning 3.25%.
In a liquidity-starved situation, the repo rate, or the rate at which RBI gives money to banks, becomes the policy rate, but in a liquidity-surplus situation that we have been witnessing for sometime, the reverse repo rate, or the rate at which the central bank sucks out liquidity, is the policy rate.
This means, without formally raising rates, RBI is being able to make the cost of money expensive for banks.
Graphics: Ahmed Raza Khan / Mint
Companies and individual borrowers will not be affected immediately as banks are unlikely to raise their lending rates for the time being. However, they will stop competing with each other to bring down the mortgage and auto loan rates.
The last time CRR was in this range was in November 2008. The repo rate at that time was 7.5% and the reverse repo rate 5%.
RBI is likely to follow up its Friday action by a hike in policy rate in April, when it announces its annual monetary policy for fiscal 2011 after the Union Budget is presented in end-February and more hikes in both policy rates as well as CRR through the year.
Indeed, the fiscal policy of the government will play a very critical role in shaping RBI’s monetary policy in next fiscal. The policy statement explicitly said, “The reversal of monetary accommodation cannot be effective unless there is also a roll back of government borrowing”.
The government is borrowing a record Rs4.5 trillion from the market to bridge its estimated 6.8% fiscal deficit in the current fiscal. “It could be managed through a host of measures that bolstered liquidity”, but those options will not be available to the same extent next year, RBI said.
On top of that, the inflation pressures will rise and credit demand from the private sector will strengthen as growth momentum in the economy gathers steam.
RBI infused Rs1.6 trillion into the system by cutting banks’ CRR by four percentage points, from 9% to 5%, in the wake of the credit crisis following the collapse of US investment bank Lehman Brothers Holdings Inc. in September 2008. The government, too, has infused Rs2.8 trillion via three stimulus packages to prop up a slowing economy.
RBI signalled an exit from its expansionary monetary policy in October 2009 as it shifted its stance from “managing the crisis” to “managing the recovery”. It shut all refinance windows and the floor for banks’ holding of government bonds was also raised from 24% to 25% of their deposits, but many of its actions at that time were academic in nature.
For instance, a one 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 financial companies, housing finance firms, mutual funds and exporters, and the closure of the window for swapping banks’ foreign exchange liabilities hardly made any difference because those facilities were rarely used.
This time around, RBI has carried forward the process of exit in a more meaningful way and it wants the government to return to a path of fiscal consolidation as well.
Despite issuing a hawkish statement, RBI has refrained from any rate hike as yet for two reasons. One, a strong anti-inflationary measure such as a rate hike may deal a blow to the economic recovery by affecting private investment and consumer spending. And, two, it wants to wait and watch for the government’s stance in the forthcoming Budget.
If the government chooses growth over fiscal prudence and continues to borrow massive amounts from the market to bridge the widening fiscal deficit, then RBI will find it difficult to aggressively tighten its policy. After all, it takes two to tango.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at firstname.lastname@example.org