BackSubbarao takes the middle path
Subbarao’s compromise formula–a cut in CRR—theoretically signals the beginning of an easing in monetary policy
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Reserve Bank of India (RBI) governor D. Subbarao seems to be a believer in majjhima patipada, or the middle path of Buddhist philosophy—moderation. So there was no rate cut in the mid-quarter policy of the central bank on Monday; instead there was a cut in banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with the central bank.
A quarter percentage point cut in CRR—from 4.75% to 4.5%—will release about ₹ 17,000 crore into the banking system.
This will make Pratip Chaudhuri, chairman of the nation’s largest lender State bank of India—who has been pushing for a CRR cut aggressively—smile but the market reaction was mixed. While bank stocks rose, bond prices fell after RBI move.
Is it a big deal? Certainly not, particularly when banks are not massively liquidity-starved.
So why has Subbarao opted for a CRR cut? Well, he was under pressure from the government to cut the policy rate. There was moral suasion by the government—a persuasion tactic generally used by the central banks to influence and pressure, not necessarily force, commercial banks into doing something that they want. A series of fiscal measures last week by the finance ministry, something Subbarao has been seeking for a long time, put tremendous pressure on him to do his bit.
But he could not go for a rate cut because inflation continues to remain high in Asia’s third largest economy. Average inflation this fiscal year is close to 7.5%, half a percentage point more than RBI’s revised year-end projection, and it can rise further because of the increase in diesel price announced last week. If the government sticks to its plan of raising the diesel price by ₹ 5 per litre,the wholesale price inflation will go up by about 60 basis points. One basis point is one-hundredth of a percentage point. The higher diesel price will push up the cost of transport as well as food and other items.
Subbarao, an inflation hawk, could not compromise on his stance. Instead, he worked on a compromise formula—a cut in CRR, to address the tightness in liquidity that may result when demand for bank credit picks up. On a similar assumption, RBI cut banks’ compulsory bond holdings, or statutory liquidity ratio, in the last policy review, to free up money that can be used for lending.
Theoretically, a cut in CRR signals the beginning of an easing in monetary policy. But it should not be taken at face value. At least, at this juncture, this cut cannot be interpreted as the end of the tight money policy. RBI could have done without it as it has been tackling the liquidity tightness through so-called open market operations (OMO)—its bond-buying programme. There was no urgent need to cut CRR even though the outflow of advance tax will drain liquidity as this will be a temporary phenomenon and the situation will improve once the government starts spending. In the recent past, we had seen a severe cash crunch in the system, but RBI did not do anything.
So why did Subbarao go for it this time? He wanted to send a signal—that the monetary policy is in sync with the fiscal policy, that he is willing to reciprocate the government’s steps for a fiscal correction and its push for reforms. There is an interesting line in the policy statement—“monetary policy also has an important role in supporting the growth revival". Till recently, he was saying just the opposite—fiscal policy has a role to play in lifting the sagging economy and RBI alone cannot be accountable for bringing back the economy to a firm growth path. In other words, he had to do something. And he did, even though he chose a softer option as the inflation threat still looms large and RBI cannot let its guard down.
Apart from high inflation, the other factor that influenced his decision against a rate reduction is the fact that RBI had cut its policy rate by a half a percentage point, from 8.5% to 8%, in April. The policy statement emphasized that the central bank “front-loaded" its policy rate cut in April. Further policy action was made subject to the government’s response on the fiscal front. With the government reciprocating RBI’s action by raising the price of diesel, limiting the supply of subsidized cooking gas, opening up multi-brand retail and allowing foreign airlines to invest in domestic carriers, and clearing divestment of government stakes in a few state-owned companies, the ground is now clear for the central bank to act. But that will not happen till inflation is controlled. A stronger rupee will help by reducing the risk of imported inflation.
However, the monetary transmission will be faster this time around and we may see banks cutting their base rate, or the minimum lending rate, to lower the cost of money. This is not because the transmission mechanism has become more efficient; there are other reasons behind it. The banking community has not passed on the benefit of the half a percentage point rate cut in April uniformly to borrowers. On top of that, there is pressure from the government. While the reforms will play the role of an enabler to kickstart the economy, cheap money is imperative to give it a booster dose. And banks, like RBI, may oblige the government, despite their reluctance. Both deposit and loan rates will move southwards.
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
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