Mumbai: As India’s central bank has dealt or tried to deal with financial and economic turmoil, acronyms and phrases unique to monetary policy and banking such as cash reserve ratio (CRR), market stabilization scheme (MSS), statutory liquidity ratio (SLR) and repo rate have repeatedly made the headlines.
That situation is unlikely to change. The Reserve Bank of India (RBI) has been cutting its policy rate and CRR over the past few weeks to ease the pressure on liquidity (or the availability of money in the financial system) and lower the borrowing cost of companies and individuals.
Over the weekend, it also cut banks’ SLR for the first time since 1997 and promised to buy back government bonds offered under MSS.
If economists and analysts are to be believed, RBI isn’t done, yet.
The Asia Policy Watch of Goldman Sachs Group Inc., released on Monday, said: “We expect continued measures to ease liquidity through CRR and SLR cuts… The repo rate to be cut by an additional 200-250 basis points by mid-2009…as inflation continues to fall sharply.”
Rajiv Malik, head of India and Asean (Association of Southeast Asian Nations) Economics at Macquarie Capital Securities, Singapore, maintains that RBI is on the path of undertaking the “mother-of-all-monetary-easings”. “In our view, RBI will have to announce further cuts in CRR, repo rates and SLR.”
What do all these measures signify for the larger economy, the banking industry and consumers? Will they work? Can they actually prompt banks to lend and stem an impending slowdown? And what do they mean?
Mint presents a rough and ready guide on four key monetary management measures and their implications:
The repo rate
The repo or repurchase rate —RBI’s main short-term lending rate—has been cut by 50 basis points to 7.5%. This is the second repo rate cut in less than a fortnight. On 20 October, RBI had cut the repo rate by 100 basis points to 8%. One basis point is one-hundredth of a percentage point. With the latest cut, the repo rate has retreated to the January 2007 level.
Unlike other central banks, RBI has two policy rates—the repo rate, at which it injects money into the financial system or lends money to banks, and the reverse repo rate, at which it sucks out excess money or borrows money from banks.
If liquidity is abundant in the system, then reverse repo becomes the key policy rate, but when money is scarce—as is the case now—and banks borrow from RBI, the repo rate is the policy rate.
Also, these two rates create the corridor or band within which the overnight call money rate—the rate at which banks borrow from each other —should move.
By cutting the repo rate by 50 basis points, this corridor has shrunk to 150 basis points (the reverse repo rate is 6% now, unchanged since October 2006).
Following the cut, the overnight call money rate should be less volatile because it has less room to move about in. Ideally, it should vary between 6% and 7.5%.
But the overnight call money rate shot up to cross 20% last Friday when the repo rate was 8%.
This means the repo rate per se has no bearing on the market rates. In fact, the market rates depend more on the availability of liquidity than the policy rates.
Similarly, a cut in the repo rate does not necessarily signify lower bank lending rates. Again, liquidity plays a key role here.
Banks do not lend to companies and individuals by borrowing from RBI.
They borrow from the central bank to take care of their temporary asset-liability mismatches. To borrow from RBI, they need to offer government bonds as collateral. If they are short of government bonds, they cannot borrow from RBI and hence they need to turn to the overnight inter-bank call money market.
At best, a cut in repo rate is a signal to banks to pare their lending and deposit rates but its effectiveness depends on liquidity in the system.
The statutory liquidity ratio
SLR has been cut by 100 basis points to 24%, the first such reduction since 1997. Following the cut, banks will be required to invest 24% of their deposits in government bonds, instead of 25%. This means they will have more cash in hand to lend to industry.
By definition, SLR bonds are liquid assets that can be sold at a short notice to meet any unexpected demand from depositors. Higher reserve requirements such as CRR and SLR make banks relatively safe (as a certain portion of their deposits are always redeemable) but at the same time restrict their capacity to lend. To that extent, lowering of reserve requirement increases the resources available with a bank to lend.
Historically, SLR of Indian banks has been high as they need to bear the burden of the government’s fiscal deficit. The government borrows from the banks every year to bridge the fiscal deficit.
And since there is no improvement in the government’s fiscal health (in fact, it is worsening), banks will continue to buy government bonds and the cut in SLR may turn out to be an academic exercise. Currently, the industry’s SLR holding is around 27.5%.
Banks use government bonds held by them in excess of their SLR requirement as collateral to borrow from RBI. On 16 September, RBI had announced, as a temporary and ad hoc measure, that banks could get additional liquidity support from the central bank up to 1% of their SLR.
That amounted to a virtual cut in SLR. This reduction has now been regularized, releasing Rs40,000 crore to the banking system for lending.
The cash reserve ratio
CRR determines the proportion of bank deposits that is to be kept with RBI. It has been cut by 100 basis points in two stages. With this, RBI has brought down CRR from 9% to its January 2007 level of 5.5%.
The outstanding deposit portfolio of the Indian banking industry is Rs34.69 trillion. This means a 100 basis points cut in CRR releases Rs34,690 crore into the system.
However, the actual amount is more—close to Rs40,000 crore.
This is because banks keep funds with RBI on what is in monetary jargon called net demand and time liabilities. This includes certain other liabilities, besides deposits.
So, in the past few weeks, a 350 basis points CRR cut had released Rs1.4 trillion.
Banks can use this money to lend. A cut in CRR also increases banks’ income. RBI does not pay any interest on the cash balance kept with it. Banks can earn 13.5-14% from the freed-up money if they lend to corporate customers with good ratings or around 7.5% if they invest in government securities.
Theoretically, the level of CRR can be brought down to zero. This means, RBI can at best release Rs2.2 trillion into the financial system to ease the liquidity constraint.
The Indian central bank will probably feel the need to cut CRR again (and again) unless it stops intervening in the foreign exchange market.
RBI has been selling dollars to stem the fall of the local currency that has fallen 20% against the US currency since January.
For every dollar RBI sells an equivalent amount of rupees is sucked out from the system.
In other words, liquidity will remain in the system if RBI stops selling dollars and allows the rupee to depreciate.
This situation can also be achieved if the supply of dollars increases with foreign institutional investors (FIIs) buying Indian equities andlocal firms borrowing overseas.
The combination of adequate liquidity and low policy rate can bring the borrowing cost down for firms and individuals.
Market stabilization scheme
Till the time the rupee was rising against the dollar, RBI was aggressively buying dollars from the market to stem the rise of the local currency. This is because a strong local currency hurts exporters’ interest as their income, in rupee terms, comes down.
For every dollar RBI sold, an equivalent amount of rupees flowed into the system and that, in turn, was sucked out by bonds, floated under the market stabilization scheme.
RBI floated both dated securities as well as treasury bills under the scheme and the so-called MSS bonds were not part of the government’s annual borrowing programme that raises money to bridge the fiscal deficit.
RBI has now decided to buy back MSS dated securities to provide another avenue for injecting liquidity.
This will be calibrated with the market borrowing programme of the Indian government.
The government is slated to borrow Rs29,000 crore till the end of this fiscal under its annual borrowing programme but Union finance minister P. Chidambaram has hinted at fresh fund-raising by the government to bridge its rising fiscal deficit.
The outstanding MSS bonds in RBI book are worth Rs1.74 trillion and out of this, dated securities account for Rs1.35 trillion with the rest being short-term treasury bills.
RBI plans to buy back part of the MSS bonds to generate cash for banks which can reinvest them in government bonds that will be floated between now and March 2009.
In other words, banks will not be required to dip into their deposit pool to buy government bonds.
The buy back will help the banks generate liquidity and the government see its borrowing programme through. However, the response of banks to the buy back programme will depend on the price of MSS bonds.
Since interest rates can only go down in coming days, banks may find staying invested in MSS bonds makes business sense.
In a low interest rate regime banks make more money in bonds as their prices go up, pulling down their yields.