Over the last fortnight, the Indian central bank has cut its policy rate by 100 basis points and banks’ cash reserve ratio (CRR), or the proportion of deposits that commercial banks need to keep with the Reserve Bank of India (RBI), by 250 basis points, releasing Rs1 trillion into the cash-starved Indian financial system.
One basis point is one-hundredth of a percentage point.
Besides, interest rates on non-resident Indian, or NRI, deposits have been raised; norms on raising external commercial borrowings relaxed; and a special Rs20,000 crore liquidity window has been opened to help mutual funds facing redemption pressure.
Clearly, the objective is to bring down interest rates, create adequate liquidity in the system and keep the rupee-dollar exchange rate at a reasonable level.
With global commodity prices declining sharply, the fear of rising inflation is disappearing fast and growth is back on RBI’s agenda. And, along with growth, it wants to maintain financial stability at any cost.
In a sense, liquidity, interest rates and exchange rate are inter-linked. RBI has cut its policy rate to improve sentiment but that has weakened the rupee further, pushing it down to a lifetime low, as attraction for rupee assets for overseas investors has waned with the interest rate differential between India and the US shrinking.
Also Read Tamal Bandyopadhyay’s earlier columns
Similarly, RBI’s dollar sales in the foreign exchange market are affecting rupee liquidity as for every dollar it sells a equivalent amount in rupee is drained from the system. So, if RBI continues to sell dollars to stem the fall of the local currency, it will need to cut CRR again and again to infuse liquidity into the financial system.
Indeed, RBI needs to be proactive to address the unprecedented liquidity crunch and banks’ extreme risk aversion for lending but, overall, the central bank’s measures smack of ad hocism, nervousness and desperation.
It seems to be trying to do too many things and expecting results overnight.
With the general election round the corner, the government has no time to wait for what, in economics, is called the “lead-lag” effect, but the central bank possibly needs to show more patience. Also, it needs to be more creative in its crisis-management strategy.
Let’s take a closer look at what markets expect RBI to do on Friday:
Policy rate cut
Unlike the US Federal Reserve and most other central banks, RBI has two policy rates—the repo rate, or the rate at which it injects liquidity into the system, and reverse repo rate, or the rate at which it sucks out liquidity.
In a liquidity-surplus situation, the effective policy rate is reverse repo rate, currently 6%. Similarly, in a liquidity-starved situation, 8% is the policy rate.
The gap between the two rates forms a corridor within which the cost of overnight money should move. Those who are pitching for a rate cut argue that the repo rate should be brought down to 7.5%, narrowing the corridor to 150 basis points. This will bring down the volatility in the overnight call money market.
This is a sensible thing to do but by bringing down the rate, RBI will end up making the rupee more vulnerable. If it wants to send a strong signal to banks and make them cut their lending rates, it needs to make sure that there is ample liquidity in the system.
This will automatically make the reverse repo rate the effective policy rate. In other words, without announcing any rate cut, RBI will bring down the policy rate by 200 basis points.
Another cut in CRR
This is inevitable, even though it may not happen on Friday. In this week alone, RBI might have spent at least $4 billion (Rs19,920 crore) in the foreign exchange market to stem the fall of the rupee, which has already lost more than 20% this year.
A weaker rupee pushes up the cost of imports and negates the benefit of the falling prices of crude to the economy, among other things. To that extent, it adds to the inflationary pressures.
As long as RBI sells dollars, it will have to continue to increase rupee liquidity in the system by cutting CRR. Every 100 basis points cut in CRR releases about Rs40,000 crore. There is no floor for CRR under banking law, which means it can be brought down to zero, but if that is done the banking regulator will not be able to talk loudly on the safety of Indian banks.
The level of CRR is an indication of the banking system’s safety, as, in case of a collapse, the money kept with the central bank acts as a sort of insurance for depositors.
Cut in SLR
Under the law, Indian banks are required to invest 25% of their deposits in government bonds, known as the statutory liquidity ratio (SLR), and any excess bond holdings can be used to borrow from RBI.
The SLR level has recently been brought to 23.5%, as a temporary measure, to help the banks and the mutual funds that have been seeing huge redemptions to use the money borrowed from RBI to lend.
An SLR cut will encourage banks to lend as they will have more money at their disposal. On the flip side, the government will find it difficult to sell its papers and raise money from the market when the SLR level goes down.
Two government bond auctions worth Rs10,000 crore each have been cancelled this month because of lack of liquidity in the system.
The government plans to borrow Rs39,000 crore between now and March 2009 and finance minister P. Chidambaram has indicated that the borrowing programme will go up to bridge a higher fiscal deficit this year.
Clearly, a cut in SLR will inconvenience the government staring at a high fiscal deficit, but it will go a long way in goading banks to lend to companies and individuals.
RBI needs to show more creativity if it wants a faster solution to the problem.
For instance, it can pay interest on banks’ CRR balance. Till last year it was paying interest on CRR but discontinued it after the amendment of an Act which allows the central bank to bring down CRR to zero (against a 3% floor kept earlier). Interest needs to be paid not to protect banks’ profitability, but to enable them to lend at lower rates.
Similarly, RBI can bring down the risk weights for certain segment such as home loans. The regulator had earlier raised the risk weights for some sectors, including real estate and personal loans, to discourage banks from aggressive lending.
Lower risk weight will bring down the cost of capital for banks.
Finally, RBI must find ways for the most productive use of its $274 billion foreign exchange reserves. It has already spent about $40 billion to defend the currency without any success. If it uses an equivalent amount to offer support to Indian banks and corporations, overnight the sentiment will change dramatically. It needs to convince Indian companies and the banking system that there won’t be any liquidity problem tomorrow. A dollar line from RBI will also take the pressure off the currency.
What’s the point in piling up such a huge foreign exchange reserve unless the central bank uses when it’s needed the most?
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org