A day after finance minister Pranab Mukherjee presented the Budget, Reserve Bank of India (RBI) governor D. Subbarao met chief executive officers (CEOs) of large commercial banks in Mumbai to hear their expectations from the quarterly review of monetary policy, slated for the last week of July. At the meeting, the CEO of one bank made a strong case for an increase in banks’ cash reserve ratio (CRR) to tackle a flood of liquidity in the banking system. CRR is the amount of cash, as a percentage of deposits, that banks need to keep in reserve with RBI and they do not earn any interest on this. Then, why did this banker seek an increase in CRR? After all, a bank can always park its excess money at RBI’s reverse repo window and earn 3.25%.
Possibly, this gentleman is not enjoying the pressure that the entire banking community has been facing from the regulator, as well as the government, to cut loan rates. The policy rate has come down from 9% in September to 3.25% now, and the fall in the Wholesale Price Index based inflation rate in the past nine months is even sharper with abundant liquidity in the system. But banks have not cut their loan rates to the extent borrowers expect them to do. The prime lending rates (PLRs) of public sector banks, which account for about three-fourths of the banking industry’s assets, now range between 11% and 12.25%, lower than the 13-14.5% seen six months ago. Domestic private and foreign banks maintain even higher loan rates. PLR is the rate at which banks’ best customers are expected to access loans.
In the first quarter of the current fiscal, bank credit grew by Rs2,749 crore, or 0.1%, compared with Rs52,111 crore, or 2.2%, in April-June 2008. But this is overall credit flow. If one looks exclusively at loans to the commercial sector, or so-called “non-food credit”, there’s a decline of around Rs7,500 crore in banks’ credit flow in the first quarter of 2009. With no sign of a pick-up in credit demand, banks are grappling with huge liquidity and pressure to cut borrowing costs and deposit rates. In the past few weeks, they have been daily parking around Rs1.4 trillion with RBI on average. In October, when a credit crunch rocked the global financial system in the aftermath of the collapse of Wall Street investment bank Lehman Brothers Holdings Inc., the Indian central bank was infusing at least Rs75,000 crore daily into the banking system. RBI sucks out liquidity through its reverse repo window and infuses liquidity through its repo window when banks need funds.
How has this liquidity been created? Where is the money coming from?
The biggest source of money is the cut in CRR. From 9% in September 2000, it has declined to 5%. And the 4 percentage point cut has infused roughly Rs1.6 trillion into the system.
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Besides, the unwinding and redemption of intervention bonds has created nearly Rs1 trillion of liquidity. The outstanding amount on such bonds, floated under the so-called Market Stabilization Scheme was Rs1.2 trillion in the first week of January. It was down Rs22,890 crore on 3 June. The bonds were floated to soak up excess liquidity created after RBI bought dollars in the foreign exchange market to check the runaway appreciation of the rupee. A strong local currency hurts the competitiveness of exporters as their real income in rupee terms declines. For every dollar that RBI bought, an equivalent amount of rupees flowed into the system.
With the dollar flow drying up and foreign institutional investors, or FIIs, staying away from Indian equities in 2008 and the first few months of 2009, the rupee dropped to 52 to a dollar in March from a high of 39.20 in early 2008. It is trading at around 49 to a dollar now. After taking out at least $12 billion (Rs58,440 crore now) from Indian equities last year, FIIs have bought close to $5.92 billion worth of equities this year (net of selling). But since RBI has not been aggressively buying dollars from the market, there is no fresh rupee liquidity being generated through this route.
Still, RBI’s bond buying under its open market operations is creating rupee liquidity. Since February, it has infused around Rs76,000 crore worth of liquidity into the system—Rs46,000 crore in February and March, and Rs30,000 crore in the first quarter of fiscal 2010.
As a result of all these moves, short-term rates have declined sharply. For instance, the rate on six-month commercial paper has dropped from around 15% in October to around 3.6% now. Similarly, the three-month treasury bill yield has dropped from 8.75% to 3.15%. But at the longer end, the yield on 10-year government bonds is still around 7%, sharply higher than the 4.86% seen in January. Loan rates also continue to be high. As bankers are not sure how long this liquidity will last, they do not want to discourage depositors by cutting deposit rates drastically. One entity that’s not complaining about the liquidity is the government, because it needs to borrow Rs4.51 trillion from the market to take care of its fiscal deficit in 2010, expected to be 6.8% of the gross domestic product. The borrowing requirement will increase further if the fiscal deficit overshoots the target. But that’s a different story.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as deputy managing editor of Mint in Mumbai. Please email comments to firstname.lastname@example.org