Consider a fable that has gained currency in the last few weeks in India. It runs roughly like this. If the Reserve Bank of India (RBI) were to inject a massive amount of liquidity into the financial system, banks would suddenly have a huge amount of money at hand and, hopefully, would begin lending again. This would ease the credit situation and interest rates would come down.
The key word here is hope. On Saturday, RBI tried to turn this fable into reality. It cut the repo rate by 50 basis points (bps) to 7.5%, the cash reserve ratio (CRR) by 100 bps to 5.5% and regularized the 100 bps cut in the statutory liquidity ratio (SLR) to 24%.
These measures are, at best, symptomatic treatment of the disease and don’t address the problem. They represent a heavier dose of a medicine that has failed to work in the recent past. This is due to a combination of confusing goals and politically driven, wrong policy responses.
First, consider why these steps are not working. As has been argued in these columns before, the problem is partly due to the contradictory goals that RBI is trying to meet. It continues to sell massive amounts of dollars in the forex market. This only sucks rupees out of circulation. For example, October has witnessed the sale of tens of billions of dollars by RBI, something as good as pushing up CRR.
What is being witnessed now is a narrowing of policy options. RBI continues to defend the rupee (which continues to slide with respect to the dollar) even as its options on CRR reduction are reaching a limit. There is some way to go before the SLR limit is reached, ?but it may soon have to draw a line after which it won’t defend the rupee. A declining rupee will mean a heavier import bill and, in turn, more inflation, but with elections soon, the government won’t permit a saner course of action. At the same time, let us not forget that inflation is still in double digits.
Illustration: Jayachandran / Mint
Under the circumstances, sorting out the problem of lending confidence may not be easy. After all, banks can view the shrinking markets and draw conclusions. There is a good chance that money lent to firms can’t be recovered because these firms cannot sell their output.
Ergo, don’t lend.
It’s here that one can see the visible hand of the government. Resolving the problem of confidence and putting in place a policy response was its duty. Clearly, it has not done its job and is now placing a ruthlessly heavy burden on monetary policy.
Will RBI’s recent steps work? Tell us, at firstname.lastname@example.org