Two sets of critical data will be released this week before India’s central bank announces its mid-quarter review of monetary policy on 16 December—wholesale price inflation in November and factory output in October.
It’s fairly certain that inflation will be down to around 9% in November from 9.73% in October. Factory output, which had expanded at 1.9% in September, the slowest in two years, will shrink in October. The decline could be as much as 5%. These two factors and a hefty cash deficit in the banking system will force the Reserve Bank of India (RBI) to change its policy direction from combating inflation to shielding economic growth amid a debt crisis in the euro zone, a US slowdown, and a fear of sub-7% growth in India.
But I would like to believe that it will not be a tearing hurry to cut banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with RBI, and policy rates, as that will signal a panic reaction than a change in policy stance.
Food inflation dropped to a 39-month low of 6.6% for the week ended 26 November, from 8% in the previous week. Since January, food inflation has been at 9% or higher in 34 out of 48 weeks and the fall is a welcome relief. Most analysts expect wholesale price inflation to drop to around 9% in November and a little over 7% by March, with the base effect catching up. Since December 2010, for 11 consecutive months, wholesale price inflation has been hovering between 9.45% and 9.78%. Factory output has been single digit since November 2010 and is likely to decline from October, something that was seen for seven successive months since December 2008 after the world was hit by an unprecedented credit crunch.
Cumulative factory output growth in the first six months of fiscal 2012, between April and September, slowed to 5% against 8.2% in the corresponding period last year. While growth in manufacturing has been slipping fast, capital goods output was negative in the previous two months and the situation may get worse as investment spending has been slowing.
Many are asking for a cut in CRR as well as the interest rate. Central banks across the globe have started loosening monetary policy with inflation being tamed and economic growth slowing amid an increasingly threatening global outlook.
Last week, the European Central Bank (ECB) cut its key interest rate by a quarter percentage point to 1% and announced it will extend long-term emergency loans to banks and other measures to stimulate lending and investing. It was the second rate cut in five weeks by ECB, the monetary authority for the 17 nations in the euro zone. China cut its CRR this month, for the first time since 2008, as Europe’s debt crisis dims the outlook for exports and growth. Cash reserve ratios have been cut by half a percentage point from 21.5% for the biggest lenders. The economy grew 9.1% in the third quarter from a year earlier, its weakest pace since the second quarter of 2009, and inflation eased to 5.5%.
Early this month, Brazil’s monetary authority reduced its benchmark interest rate by half a percentage point to 11%, the third consecutive cut since August when the rate was 12.5%. The Australian central bank, too, cut interest rates by a quarter percentage point to 4.25%, its second cut in two months. Indonesia’s central bank kept its policy rate unchanged at 6% last week after cutting it by three-quarters of a percentage point over the previous two months, joining neighbours in changing policy direction. The Philippines, Malaysia, New Zealand and South Korea also kept rates unchanged at their latest meetings but Thailand lowered borrowing costs.
Slowing growth and lower inflation will encourage RBI to change its policy direction, but it may not happen too soon as inflation will remain higher than the policy rate, possibly till December, and even though food inflation is coming down sharply, we don’t know yet the level of the non-food manufacturing inflation, a proxy for core inflation. Besides, the local currency, which hit its lifetime low of 52.75 to a dollar in November, continues to be under speculative attack. The rupee, Asia’s worst performing currency, has lost about 15% since August. A loose monetary policy will encourage banks to punt on the rupee and push it down further.
This is why RBI may not be in a hurry to bring down the policy rate and ease the liquidity tightness in the system by releasing money through a cut in CRR. Instead, it may continue to sell bonds under the so-called open market operations. It has offered to sell Rs 30,000 worth of bonds so far and with the yield on bonds falling and prices rising, banks have started participating in these auctions. They had reservations earlier as they did not want to sell bonds at a loss to generate liquidity that can be used to give loans to borrowers. With bond prices rising, they don’t need to book losses.
Indeed, the cash deficit in the system will rise and cross Rs 1 trillion daily later this week when Indian firms pay advance taxes for the December quarter, but banks can borrow from RBI at 8.5% as they have enough government bonds in their portfolio to offer as collateral. Under norms, banks are required to invest at least 24% of their deposits in bonds known as statutory liquidity ratio (SLR) and any extra bond holding can be offered as collateral to borrow money from RBI. The industry’s current SLR holding is about 29%.
Also, banks’ need for money may not be acute as the industry’s credit growth has dropped to 17.6% against 22.7% a year ago. Since the beginning of this fiscal, credit growth has been 6.4% against 10% last year. With deposits growing at a higher rate than loans, banks can take care of the needs of their borrowers for the time being.
We may see a CRR cut in January and rate cut in March. After a series of 13 rate hikes since March 2010, RBI may pare its policy rate from 8.5% to 7.5% or even lower it in phases next year as the cost of money is key to investment decisions of firms that can help prop up a sagging economy.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at firstname.lastname@example.org
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