The Reserve Bank of India’s surprise decision to retrospectively impose incremental cash reserve ratio (CRR) of 100% on the increase in banks’ net demand and time liabilities over 16 September-11 November has created uncertainty.
The most immediate and obvious impact is upon interest rate expectations.
The CRR shock checked the fall in bond yields which, driven by heavy bond buying by banks amidst a liquidity glut and anticipation of steep interest rate declines, slipped below the repo rate (6.25%) last week. This was a clear concern for the central bank in the context of an expected increase in US interest rates and the rapid reversal of foreign capital from emerging markets including India.
But employing the CRR tool to absorb an estimated Rs3.5 trillion after allowing a long drift in expectations in another direction has sowed many doubts amongst banks and market participants.
For one, future monetary transmission has turned ambiguous as the CRR hurts the profitability and finances of banks, which are not in good shape. In the last fortnight, hopes rested upon improved ability of banks to pass on their lowered funding costs from an expanded deposit base. Several banks had lowered their deposit rates, creating grounds for belief that lending rates will soon follow suit. State Bank of India, for instance, reduced its bulk term deposit rate by 120-190 basis points. One basis point is one-hundredth of a percentage point. Markets were positioning likewise.
Now, banks will earn nothing on these deposits (understood to be contracted at interest rates ranging over 3-6%, the bulk being high-cost fixed deposits) against the previously assumed 5.75% from parking these with the RBI. Banks will recalculate their marginal cost of funds—92% of this is determined by their marginal borrowing cost that decides how much can be passed on to their borrowers. This leads to uncertainty about the extent of monetary transmission banks might be able to deliver. The much-anticipated easier interest rate environment following demonetization is now more uncertain, as is a policy rate reduction in the forthcoming monetary review on 7 December.
Interest rate cuts by banks are surely delayed as there is uncertainty about what comes next by way of managing the liquidity deluge, even though the central bank said its action will be reviewed. Separately, the RBI governor reportedly said this would be reviewed once the government issues enough market stabilization scheme or MSS bonds. But given the backward-looking nature of the CRR action, there will be a wait for greater clarity on further measures and operating principles in this regard. This adds to the existing unknowns about how much more demonetized currency is likely to return to the banks, how much has been replaced and remains in the system.
Then, while the MSS instrument has been mentioned, it is not certain as to what would be the quantum and duration of deployment. Past MSS limits have been very small in comparison to magnitudes required for an extraordinary event like the current demonetization with no previous experience or precedents to draw upon. There are also associated fiscal risks that markets cannot ignore when public balances are consolidating and there is no knowledge how much higher tax revenue demonetization would be able to generate. Uncertainties about how the costs of managing liquidity unleashed by demonetization are to be distributed will persist unless the RBI presents a clear picture.
Renu Kohli is a New Delhi-based economist.