In leaving its key lending rate unchanged but raising the level of cash that commercial banks have to keep with it, the Reserve Bank of India (RBI) signalled a clear shift in its monetary policy strategy.
The central bank is no longer targeting interest rates, but instead, it is targeting what it sees as a surfeit of liquidity in the system, stemming from increased government spending as well as the bank’s own aggressive intervention in the foreign exchange market.
RBI has continuously been buying dollars in the market to keep a lid on the appreciation of the rupee, which hit a nine-year-high last week, and over the last three months, an additional Rs24,000 crore has flown into the system as, for every dollar that the bank buys, an equivalent amount of rupees flow in.
“Managing liquidity has become the most challenging task,” said RBI governor Yaga Venugopal Reddy, adding that the bank’s stance continues to remain the same: managing growth and price stability.
On Tuesday, RBI raised the level of cash that commercial banks are required to keep with the Indian central bank, known as CRR, from 6.5% to 7% of their deposits.
Despite that move, analysts were quick to suggest that the central bank is not yet through with its tightening cycle and that they expect another round of CRR hike, perhaps even a lending rate hike, by October, when RBI reviews its monetary policy again.
The latest hike in the CRR will take effect from 4 August and will remove about Rs16,000 crore from commercial banks.
The Bombay Stock Exchange’s benchmark index, Sensex, jumped 291 points, or 1.9%, to 15,550.99, while the broader National Stock Exchange’s Nifty index rose 2%, or 88.8 points, to close at 4,528.85, as investors reacted to stable lending rate and ignored other moves. The rupee ended at Rs40.3725 to a dollar and within striking distance of last week’s peak of Rs40.20, the strongest since May 1998.
In its quarterly review of monetary policy, the bank also lifted the cap that it had imposed on its liquidity absorption from the banking system.
Since March 2007, RBI has been draining up to Rs3,000 crore of excess liquidity each day from banks at a 6% interest rate. From 6 August, commercial banks can now park any amount of excess liquidity with RBI. The removal of the cap on liquidity absorption will establish a floor for the overnight rates—interest rates that banks can get on excess money—that have been veering at near-zero because too many banks had too much money to park.
Singapore-based economist Rajeev Malik of JPMorgan Chase Bank says the bank’s CRR move, which will drain Rs16,000 crore out from the system, will account for about 40% of the current excess liquidity. RBI is also holding a bond auction of Rs10,000 on 3 August, and an additional Rs5,000 crore will also be stamped out this week through yet another auction under a special government scheme, devised to absorb excess liquidity.
“Rs31,000 crore will be taken out of the system through all these but RBI is not yet through with its tightening cycle,” says A. Prasanna, vice-president with ICICI Securities Ltd, which buys and sells government bonds. “We won’t be surprised if the central bank hikes its policy rate and goes for another round of hike in CRR in October.”
Added Robert Prior-Wandesforde, an economist with HSBC’s Asian economics team: “We wouldn’t be surprised to see some renewed tightening in 2008 as it becomes clear that inflation is far from dead in India. Meanwhile, further CRR hikes will depend on the liquidity situation, but it is probably wise to pencil in a further 50 basis points move before the year-end.”
Commercial banks said they are not planning to raise lending rates to absorb the impact of the latest CRR hike. Instead, some of the banks may lower their deposit rates to keep the spread—the margin between their cost of deposits and income on loan assets—intact. Bank of India, in fact, took the lead by cutting its one-year deposit rate by 0.50% to 9% hours after the announcement of the RBI policy.
Canara Bank CEO M.B.N. Rao, too, hinted at lowering interest rates for deposits of up to one year.
Banks will indeed be hurt by the hike in CRR as they do not earn any interest on the cash kept with RBI. However, the lifting of cap on RBI’s excess liquidity absorption will compensate the hike. Until now, banks could only park up to Rs3,000 crore excess liquidity with RBI and the rest was going to the overnight market where returns dropped to near-zero on oversupply of money. Now, they could earn 6% interest when they park their excess liquidity with RBI.
“The impact on CRR hike is revenue neutral for my bank,” said K.C. Chakrabarty, chairman of Delhi-based Punjab National Bank. “We will not get any interest on our additional 0.50% deposits to be kept with RBI, but since we have surplus liquidity, we will earn 6% interest on that,” he added. Mumbai-based Union Bank’s CEO M.V. Nair said his bank would take a hit of around Rs26 crore on account of the CRR hike.
Bond dealers were relieved with the RBI move and noted that the market now has a direction. “We won’t have to take a blind call any more,” said the chief dealer of a private bank, who did not wish to be named. With the previous Rs3,000 crore cap, excess liquidity that was diverted by banks to the overnight market drove down the overnight rates and pulled down the yields on government bonds.
The yield on 10-year bonds on Tuesday rose from 7.76% to 7.85%. The rise was sharper at the shorter end, with the one-year treasury bill yield rising from 6.40% to 7% and three-month treasury bill yield zooming from 4.5% to 6%.
“Despite the hike in CRR, there will be surplus cash left in the system and this should keep long-term yields in check. In short, we are looking at a much flatter yield curve in the near term,” said Abheek Barua, chief economist, HDFC Bank Ltd.
HSBC’s economists expect RBI’s measures to have a temporary effect and wrote that “unless economic growth softens far more than we or anybody else expects, the authorities will probably have to sanction a renewed currency appreciation at some point in the not-too-distant future.” JPMorgan believes RBI will keep policy rates on hold but strong capital inflows could prompt the central bank to hike CRR again before the next policy review on 30 October.