Is the current deficit in liquidity structural, as the Reserve Bank of India (RBI) has stated? RBI itself suggests that the explanation lies elsewhere. Deputy governor Subir Gokarn recently said the reason behind the cash crunch was the mismatch in credit-deposit growth. The pace of credit growth is automatically causing a big, persistent tightening in liquidity; deposit growth is only now expected to respond to higher interest rates in the coming months. That’s an indication that policy rates have lagged behind. Alternatively, one may ask: Has inflation overshot the predicted path?
Also See | Inflation and deposit growth (Graphic)
The deceleration in deposit growth has been a normal reaction to inflation and negative real interest rates, just as the rising credit demand is a regular response to a higher pace of economic activity. These are movements in response to the economic cycle, which can be characterized as a high inflation and growth phase over the last three quarters.
Deposit growth has actually been slackening since July 2009, in inverse proportion to inflation. Aggregate deposit growth—RBI in April projected this at 18% for 2010-11—was last observed at these levels in November 2009; throughout this financial year, it has been at least 3-4 percentage points below this projection. In April, this author noted the growing divergence in monetary aggregates in this paper: acceleration in M1 growth—currency in circulation plus demand deposits—from June 2009 onwards; M1 growth outpacing M3 growth (this adds time deposits to M1) beyond December 2009.
This trend reflected the fact that money balances were shifting from time deposits, or savings, to current accounts and cash with the public (also known as dissaving): real returns were negative, transactions demand for money was rising due to inflation, and maybe some of the cash was being diverted into property and stocks, further aggravating prices.
The key point here is that these behavioural responses are not new, as the accompanying chart shows. Whenever inflation shoots up sharply and real interest rates turn negative or very low, so as to yield negligible returns—for example, in 2002-03 (I) and 2007-2008 (II)—money flees from savings into currency holdings, widening the M1-M3 gap.
This behaviour is a direct function of real interest rates. It is also a good proxy of households’ inflationary expectations; sure enough, RBI’s own survey of households matches this trend, showing that inflation expectations rose consistently from the second quarter of 2009. According to an International Monetary Fund (IMF) working paper by RBI staffers M.D. Patra and P. Ray, the real interest rate has a significant impact on anticipated inflation, exceeding that of changes in fiscal policy and exchange rate.
So, if past trends are any guide, the liquidity outcome is unsurprising. With the economy racing above 8.5% growth for three successive quarters and inflation mostly exceeding these numbers, real interest rates have been negative from December 2009. And, as the chart shows, the gap between the 10-year government bond yield and year-on-year Wholesale Price Index (WPI) inflation has been more than two percentage points from January to July.
The credit-deposit ratio, which tells us about the lending capacity of the banks, has remained stretched between 72-73% since April; this zoomed to nearly 75% in November, as all three segments of the economy—agriculture, industry and services—recovered, leading to the current squeeze.
To be fair, RBI voiced its concern—that negative rates were eroding returns to savers and discouraging deposit growth—in the September review of monetary policy. It also seized the opportunity afforded by tight liquidity conditions in May-June, and shifted the operative policy rate from reverse repo to repo in the July review, effectively tightening it in one swoop by 125 basis points (bps) to 5.75% (also suggesting that the baby-step approach had perhaps been ineffective in containing inflationary expectations and that monetary response had been falling behind).
But with growth projections also raised to 8.5% (from 8% in April) at the same time, and inflation averaging 10% in July and above 8.5% in August-October, the subsequent hikes of 25 bps each in September and November, respectively, have perhaps been less than adequate given the inflation-growth dynamics. And, since monetary action takes effect with a lag, these hikes were possibly a tad late, notwithstanding concerns about growth following the 2008 crisis.
Has this been a case of too little, too late, then? The persistent liquidity deficit at this juncture could be structural because of the fundamental imbalance between assets and liabilities of the banks. But the imbalance itself is a consequence of policy; institutional, technical or organizational factors have little to do with it. Policy intervention—leading to positive real interest rates—can help correct the situation, which is what is beginning to happen now.
Renu Kohli is an economist and a former staff member at the International Monetary Fund and the Reserve Bank of India.
Graphic by Yogesh Kumar/Mint
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