It’s given that the Indian central bank will hike its policy rate once again when it unveils the annual monetary policy on Tuesday, the ninth raise since March 2010, even as economists and analysts are debating on the exact quantum of the hike. Will governor D. Subbarao continue with the central bank’s “baby steps” of raising the policy rate by a quarter percentage point or take a “giant stride” of a half percentage point hike to fight persistently high inflation in the world’s second fastest growing economy?
Also See | Charting RBI’s Policy Direction (PDF)
Similarly, it’s fairly certain that the Reserve Bank of India (RBI) will pare its projection for economic growth for fiscal 2012 and raise inflation estimates for the year. In the last annual policy, it had projected 8.5% growth in India’s gross domestic product (GDP) for fiscal 2011. In the third quarter policy review in January, the growth projection was retained with “an upward bias”. It will probably pare the growth projection to 8.1-8.2% in the annual policy and revise it downward later. Finance minister Pranab Mukherjee projected 9% growth in his February budget speech.
While RBI’s growth projection for fiscal 2011 was realistic, it failed miserably in its wholesale price-based inflation (WPI) estimate. The initial estimate was 5.5%, which was raised to 7% in January and 8% in March and yet it was wide off the mark as WPI in March rose 8.98%. This provisional figure, when revised, could get close to 10%. Against this backdrop, RBI is expected to be cautious on its inflation guidance. Most analysts are expecting 8-8.5% average inflation in fiscal 2012.
While a hike in rates as well as inflation guidance and lower economic growth projection for fiscal 2012 will be the main highlights of the policy document, I expect many more critical announcements in the 2012 annual policy that will have a seminal impact on the financial system and Indian consumers.
Savings bank rate hike
For instance, as a precursor to the deregulation of the savings bank rate, the last bastion of mandated rates in the Indian banking system, RBI will probably raise the rate by 50 basis points (bps), from 3.5% to 4%. One basis point is one-hundredth of a percentage point. If indeed that happens, it will be the first hike in the savings bank rate in the past 19 years. The last time the savings bank interest rate was raised was in April 1992. Since March 2003, it has been kept unchanged at 3.5%.
Why would RBI raise the rate? Well, it could be a tactical ploy to take the sting out of banks’ opposition to deregulation of the rate. RBI last week circulated a discussion paper on savings bank deregulation and sought feedback from the industry and public on this, but even before the paper was released, the banking system started protesting the move, fearing a rate war and rise in the cost of deposits.
Facing stiff opposition from the banks, RBI has not been able to free savings bank deposit rates even though all other deposit rates were deregulated by 1998. It had first explored the option of freeing the savings bank rate in 2003 and later in 2007. Once the rate is raised, banks will be less aggressive in opposing RBI’s move as their cost of deposits will rise even without deregulation.
Roughly, savings bank deposits constitute about 22% of the Rs 53.25 trillion deposit portfolio of the Indian banking industry. If the rate is raised by 50 bps, banks’ cost will rise by Rs 6,000 crore—about 11% of the banking industry’s 2010 profit (all banks have not announced their 2011 earnings as yet) —and affect the net interest margin or the spread between cost of deposits and yield on advances of banks.
Savers will benefit from this as they have been persistently earning negative returns from savings bank accounts with average inflation in fiscal 2011 ruling at 9.4%.
Single policy rate
RBI may also make an important structural shift-from a two-policy rate to a single-policy rate system.
Technically, it has three policy rates, but one of these, the bank rate-last changed in 2003-is defunct. The central bank has been managing its monetary policy through two rates-the repo rate or the rate at which banks raise money from RBI, and the reverse repo rate or the rate at which they lend money to the central bank.
In a tight liquidity situation —which has been the case for past one-and-a-half years—the repo rate is the policy rate. But when there is excess liquidity in the system and banks are parking money with RBI, the reverse repo rate becomes the policy rate. We had seen that in 2009-10.
The repo rate is now 6.75% and the reverse repo 5.75%. The difference between the two rates is the liquidity corridor, technically known as liquidity adjustment facility (LAF). The rates of the overnight call money market—where banks lend to each other to help tide over their temporary asset-liability mismatches—are expected to rule between the two rates.
The Tuesday policy is set to redefine the repo rate as India’s main policy rate and both the reverse repo rate as well as the bank rate will be linked to it. This means RBI will only change the repo rate and the other two rates will change automatically. This has not been the case now.
In the new regime, the bank rate will be repositioned as a discount rate through which RBI will inject liquidity in the system in exceptional circumstances against collateral of bonds. There will, however, be a limit to what extent banks can borrow money from RBI through this window-1% of their deposit base. In such times, banks’ statutory liquidity ratio (SLR) requirement will be pared by 1 percentage point.
Under current norms, banks need to invest at least 24% of their deposits in government bonds, known as SLR. So, they will be allowed to bring it down to 23% and use the excess bonds to offer as collateral and raise money. Of course, they will have to pay half a percentage point higher than the repo rate to access this facility. The reverse repo rate will continue to be 1 percentage point less than repo rate.
This means, if the repo rate is raised to 7.25%, the bank rate will be 7.50% and reverse repo rate 6.25%.
To make the repo rate the key policy rate, the system should always run in a cash-deficit mode as has been the case with most developed markets. This will be RBI’s biggest challenge. It will also need to have a grip on the liquidity situation—not an easy task as we have seen extreme volatility in the recent past. For instance, in mid-March the government’s cash balance with RBI was about Rs 1 trillion, but in April the government was borrowing Rs 50,000 crore from the central bank—a swing of Rs 1.5 trillion in a month. Once RBI shifts to a single policy rate, the monetary policy and transmission will be quicker.
I am also fairly certain that RBI will formally accept the Malegam panel recommendations on regulating the Rs 22,000 crore Indian microfinance industry in this policy with minor tweaks. The industry has been reeling under a crisis ever since the Andhra Pradesh government passed a law restricting the microlenders’ activities in the southern state that accounts for roughly one-fourth of their market.
The Malegam panel has made several recommendations, including capping the annual family income of the borrower at Rs 50,000; a ceiling on loans to a single borrower (of Rs 25,000); and said not more than two microfinance institutions (MFIs) can lend to a particular borrower.
RBI, I think, will announce a framework for regulating the microfinance industry and make it abundantly clear that if such institutions want to access money from banks, they will have to conform to the regulations. This will not make the Andhra Pradesh law redundant, but prevent the contagion of such a law in other Indian states, and if MFIs agree to follow the RBI norms, the Andhra Pradesh government may not push for the implementation of the law aggressively.
MFIs’ business in the southern state has taken a severe beating and the loan repayment rate from borrowers has dropped to 10%. Rising defaults have made the banks wary of giving money to such institutions, and quite a few of them are facing closure of business as borrowers are not paying back their money and bankers are unwilling to give fresh loans.
Under current norms, banks are required to give 40% of their loans to agriculture and small businesses, defined as a priority sector. Their exposure to MFIs, too, is recognized as priority sector loans. MFIs typically borrow from banks at 12-14% and give tiny loans to borrowers in rural India at 24-30%.
Unless MFIs agree to be regulated by RBI, banks’ exposure to such institutions will lose the priority sector tag. Once that happens, there will not be any incentive for banks to lend money to MFIs. They do so now as they find it difficult to lend directly to farmers and small rural businesses 40% of their loans.
50 bps rate hike?
Finally, what could be the quantum of the rate hike? Many analysts believe Subbarao will stick to the bank’s stance of a calibrated approach—25 bps hike at a time. Since March 2010, there have been eight such hikes and yet RBI has not been able to tame inflation, and more importantly, inflationary expectations. The annual average inflation figure for fiscal 2011 now works out to 9.43%, the highest since 1995, and it could be even higher when provisional figures of February and March are revised.
What started as food inflation has fast spilled over to other sectors. In February, food inflation came down from 15.7% to 10.65%, but the so-called core inflation, or non-food manufacturing inflation, rose sharply from 4.8% in January to 6.1%. Food inflation dropped further to 9.47% in March and non-food manufacturing inflation rose to a two-and-a-half year high of 7.08%.
Despite eight rate hikes, the policy rate in India continues to be accommodative as inflation is ruling higher than it. In its mid-quarter December review, RBI did not raise its policy rate and in March, refrained from raising the rate by 50 bps even after raising its year-end inflation projection for the second time in a year. The reason behind this was its concerns about growth.
The factory output figures were showing softness with the industrial production index growing 3.6% year-on-year in February, below the revised 3.9% in January and, at least, 150 bps lower than analysts’ expectations. The decline of the capital goods index also continued—18.4% fall in February after 18.8% drop in January—signalling a weak investment climate.
RBI can use this excuse this time too and take yet another baby step. After all, it will meet again in six weeks and can hike the rate again.
By that time, it will also have a better idea about the progress of the monsoon, a critical input for gauging prospects of economic growth.
But a calibrated approach may not be enough to curb inflationary expectations. If RBI believes growth can be bought at the cost of inflation, then it’s a different story altogether. But if it doesn’t, then it must demonstrate its resolve to fight inflationary expectations firmly and that can be done only if it goes for a 50 bps hike. The policy rate is at least 75 bps away from where it should be by mid-2012 and there is no harm in front-loading it. This, along with higher capital requirement for certain loans, will make them expensive and dampen demand pressure.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai.
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