Ever since he took over in September as the Reserve Bank of India (RBI) governor, D. Subbarao has aggressively lowered policy rates and released plenty of money into the system by paring the cash reserve ratio (CRR), or the portion of deposits commercial banks need to keep with the central bank.
This was done to fight the severe credit crunch that the financial system faced in the wake of the collapse of Wall Street investment bank Lehman Brothers Holdings Inc.
Will he opt for another round of rate cut this week? Is there a case for a further cut in CRR? Many economists and financial sector analysts believe so. According to them, RBI is not through with its monetary easing yet. They are punting on a 50 basis point cut in both the repo as well as reverse repo rates at the policy meeting and a 100 basis point cut over the next few months. One basis point is one-hundredth of a percentage point.
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The repo rate, at which the central bank infuses liquidity into the system, is currently 5%, and the reverse repo rate, at which it sucks out liquidity, is 3.5%— both at their lowest. At least a few of these analysts are expecting a cut in CRR as well along with the policy rates.
Why should RBI cut rates? There are plenty of reasons, they say. The most important of them is slowing loan growth. In fiscal 2009, the loan growth was 17.3% against 22.3% in 2008, and much lower than the central bank’s target of 24%. A lower policy rate will drive down banks’ loan rate and create demand for money from corporations and individuals. Unless they borrow more and invest, the economic slowdown cannot be arrested.
The near-zero inflation rate is another factor that analysts believe will encourage the central bank to lower its policy rates. The year-on-year inflation, as measured by the Wholesale Price Index, dropped to 0.18% in the first week of April, and it could drop to -2% in the next few months.
A very high government borrowing programme in fiscal 2010 should also prompt RBI to cut its policy rates and increase liquidity in the system by paring CRR. Till recently, bond yields were high and out of sync with the overall interest rate architecture. The government needs to borrow a huge amount this year to plug its burgeoning fiscal deficit, being created by the fiscal stimulus packages to fight the economic slowdown. Unless more money is pumped in through a CRR cut, banks will be left with very few resources to lend to firms and individuals after meeting the government’s demand for funds.
Finally, the central banks of most of the developed economies have brought down their policy rates to zero or near-zero level. Indeed, there are some early signs of stabilization on the macroeconomic front with mild upticks seen in demand for passenger and commercial vehicles, steel and cement, but RBI should not press the pause button yet. It should continue with its expansionary monetary policy as there is more room for cuts in rates as well as CRR, these analysts say.
I also feel there is room for paring rates and CRR, but RBI doesn’t need to do this at its annual monetary policy meeting. What’s the hurry? Since 16 September, when RBI unleashed its first set of emergency policy measures by allowing banks to invest up to 24% of their deposits in government bonds, instead of 25%, thereby releasing some Rs40,000 crore into the system, the Indian central bank has generated Rs3.9 trillion of liquidity, about 7% of the country’s gross domestic product (GDP). Besides, the government’s fiscal stimulus packages account for another 3% of GDP.
We are seeing the impact of these measures now. The credit crunch is easing and banks are slowly starting to lend. There has been a substantial drop in the benchmark 10-year bond yield, indicating that normalcy is returning to the government bond market. And there is plenty of liquidity in the system. On many days in April, banks have parked at least Rs1 trillion with RBI’s reverse repo window.
Since October 2008, RBI has cut CRR by 400 basis points, from 9% to 5%. The cut in its policy rate is even sharper. At the height of the liquidity crunch, the repo rate, or the rate at which RBI lends money, was the policy rate. Now, the reverse repo rate is the policy rate. Going by this yardstick, the policy rate has been cut by 550 basis points, from 9% to 3.5%. RBI possibly cannot bring down the rate below 3.5%, the level of the mandated savings rate in India.
The challenge before RBI at this point is to make commercial banks cut their prime lending rates, or PLR. Most banks have cut their deposit rates in April and started paring their PLR slowly. Technically, banks are expected to lend to their most creditworthy borrowers at the prime rate but all of them have been keeping their PLR at an artificially high level and actually lending to many of their borrowers at below PLR. If they are banned from lending at below PLR, they will have no choice but to cut their prime rate. Similarly, RBI can also cap banks’ exposure to the reverse repo window. Banks earn a risk-free 3.5% by parking excess liquidity with RBI daily. Once they are not allowed to do so freely, they will be forced to lend.
There is no need to cut policy rates and CRR now.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as a deputy managing editor of Mint. Please email comments to firstname.lastname@example.org