Going by Reserve Bank of India (RBI) governor D. Subbarao’s track record, the quarterly monetary policy review on Tuesday represents a giant leap of faith in pushing for growth in Asia’s third largest economy.
A firm believer of “baby steps”, Subbarao has never combined a policy rate cut with a reduction in banks’ cash reserve ratio (CRR) since taking the helm of RBI in September 2008 just after the collapse of US investment bank Lehman Brothers Holdings Inc.
By cutting both the repo rate and CRR by a quarter of a percentage point each, Subbarao signalled the beginning of a relatively easy money policy. Banks are expected to reduce their lending rates in the next few days, making money cheaper for companies and consumers, and also cut their deposit rates.
This will prop up sentiment and certainly help lift India’s sagging investment climate in the next fiscal that begins in April.
RBI’s repo rate, at which it lends short-term money to banks, is now 7.75%, a level last seen in May 2011. CRR, or the portion of deposits that commercial banks need to keep with RBI (on which they don’t earn any interest), is 4%—the level it was at nearly four decades ago, in December 1974.
In RBI’s history, the lowest CRR was in September 1962—3%. It could go to that level in the next one year if liquidity remains constrained. There is no floor for CRR now and theoretically it can be even 1% or less but since the reserve requirement is a safety measure for depositors, the regulator will not be that aggressive.
When Subbarao shifted from North Block to Mint Road, transforming from finance secretary to central bank governor, both repo rate and CRR were at 9% and the world was reeling under an unprecedented credit crunch. Between October 2008 and April 2009, he brought the repo rate down to 4.75% and CRR to 5%.
By early 2010, the rate-tightening cycle started—first with a hike in CRR in February and then a rate increase in March. At its recent peak, CRR was 6% till it was cut in January 2012, and the repo rate was 8% till April 2012 before Subbarao went for a deep half a percentage point cut. This he did on an implicit understanding with the finance ministry that it would take appropriate steps to rein in the rising fiscal deficit by cutting wasteful expenditure and various subsidies.
It took nine months for RBI to go in for a second rate cut as inflation remained at an elevated level and the finance ministry did nothing till September to push for fiscal corrections. RBI, however, cut CRR in phases to infuse liquidity into the system.
The twin-cut action is more potent than even a half a percentage point rate cut in isolation. The banks will be left with no choice now but to reciprocate. By cutting its year-end inflation projection to 6.8% from 7.5% and growth projection from 5.8% to 5.5%, the RBI policy review made it clear that there will be more rate cuts in the future even though Subbarao tempered expectations by saying the moderation in inflation will be muted in fiscal 2014 as food inflation remains elevated and the impact of phased deregulation of diesel price will be felt.
But one can safely presume that the policy rate will move southwards in the coming months, provided the February Union Budget is not a populist one and the finance ministry does not lose sight of fiscal corrections ahead of general election in 2014.
The next mid-quarter review of monetary policy is on 19 March and the annual policy for the next fiscal is on 3 May. If inflation continues to decelerate, RBI may go for another cut in the next review and even another, if required, in May.
The ball is now in finance minister P. Chidambaram’s court. Since September, he has taken a series of steps to push for reforms, attract foreign money and correct the fiscal profligacy of the government. If he continues with his stance in the budget, RBI will definitely take the easy money cycle forward. The worst could be over for the Indian economy.
Tamal Bandyopadhyay keeps a close eye on everything banking from his perch as Mint’s deputy managing editor in Mumbai. He is also the author of A Bank for the Buck, a book on HDFC Bank. Comments are welcome at firstname.lastname@example.org
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