How long does it take for the Reserve Bank of India (RBI) to change its mind completely? Eight days. In its mid-term review of monetary policy on 24 October, the central bank had said, “Going forward, the Reserve Bank’s policy endeavour would be to modulate the monetary overhang generated by the sustained expansion of money supply since 2005-06." In its review, RBI maintained that the rate of growth of money supply was too high, a close watch was needed on inflation and maintained that “such a rapid rate of credit growth is a cause for concern and will warrant intensified monitoring and continued correction".

What has changed in these eight days that could have led to RBI’s policy U-turn? Not credit growth or money supply growth, but a sharp spike in the overnight rate. Overnight Mibor spiked to 20.3% last Friday, sending banks rushing to borrow from RBI. Shouldn’t RBI have foreseen this tightness? Of course it should have, considering that it was sucking out liquidity daily in its efforts to defend the dollar. But then, monetary policy is not made at RBI these days. Still, better late than never.

The other factor that provides comfort to RBI is falling prices. Not just falling inflation, but falling prices. The Wholesale Price Index, or WPI, had fallen from 241.4 on 2 August to 238.8 on 11 October, though this data, too, was already available to the central bank at the time of its mid-term review. Since then, WPI has fallen further to 238.3 on 18 October. That means wholesale prices have fallen 1.3% in the last two-and-a-half months and it has remained more or less at the same level since the end of June, which means prices have been stable for four months now.

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Shrinking balance sheet

A glance at RBI’s Weekly Statistical Supplement is enough to show why money is so scarce. Between 3 and 24 October, reserve money contracted from Rs9.94 trillion to Rs8.67 trillion, a reduction of 14.6% in three weeks. Reserve money is essentially the fresh money released to the economy by RBI and such a sharp contraction in the monetary base is the reason behind the drying up of liquidity. Reserve money was Rs9.28 trillion on 31 March.

Another way to look at central bank liquidity, or the lack of it, is to consider RBI’s balance sheet. On 3 October, RBI’s total balance sheet size was Rs15.25 trillion. Three weeks later it had fallen to Rs13.7 trillion, a contraction of 10%.

As expected, one big reason for the contraction in reserve money has been the falling net foreign exchange assets with RBI. These declined by Rs43,061 crore between 3 and 24 October.

But the biggest reason was the fall in net RBI credit outstanding to the government. This dropped by Rs84,549 crore during the three weeks, implying that deposit liabilities against government including the funds received under the market stabilization scheme (MSS) have been much larger than RBI’s holdings of government securities and its ways and means advances to the government.

Estimates put the total amount of liquidity that will be released as a result of the RBI’s policy actions at Rs1.8 trillion (cash reserve ratio cut—Rs40,000 crore+statutory liquidity ratio or SLR cut—Rs40,000 crore+special refinance facility—Rs40,000 crore+Rs60,000 crore for non-banking financial companies and mutual funds). That’s well above the contraction of Rs1.27 trillion in reserve money in the three weeks from 3 to 24 October. By that admittedly facile calculation, the liquidity let loose by the new measures should last a month or so.

But then, as RBI points out, buying back of MSS securities will provide an “avenue for injecting liquidity of a more durable nature into the system". MSS balances with RBI on 24 October amounted to Rs1.65 trillion.

Credit crunch for firms

The two major reasons for the pressure on liquidity are: RBI’s attempt to defend the rupee and companies’ inability to tap alternative sources of funding, including the equity markets and overseas funding, which forces them to turn to the local credit market.

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While the result of RBI’s attempts to define the rupee has been detailed above, what has been the impact of the drying up of alternative sources of funding? RBI data is now available for non-bank sources of corporate funding for Q1 of FY09. The data shows that these sources, which include external commercial borrowings, capital issues, commercial paper, American depository receipts and global depository receipts together amounted to Rs35,006 crore, against Rs59,600 crore in the first quarter of FY08, a fall of 41%. The shortfall was made up by domestic borrowing and is the reason why non-food credit growth is so high despite a slowing economy.

Here’s the reason for the credit crunch: the RBI data shows that total sources of funds to industry amounted to Rs94,115 crore in Q1 FY09, against Rs86,869 crore in Q1 FY08, a growth of 8.3%. But GDP growth in Q1 FY09 has been 7.9% at constant prices and 16.3% at current prices. Since resources are available to firms only at current prices, that should be the more relevant rate of growth for companies. Simply put, the amount of funds available to the corporate sector has not been enough to take care of their growth.

The situation has further deteriorated in subsequent months, because even short-term external financing has become unavailable, thanks to the spike in risk aversion. For instance, the EMBI+ index, which measures the average spread between emerging market bonds and US treasuries, shot up from around 350 at the end of September to a high of 865 on 24 October, before falling back to a still-very-high 629 on 31 October.

The primary market for stocks has also completely dried up. Moreover, corporate profits too are fast disappearing. For instance, a capital market study of 1,750 companies shows that profits after tax (PAT) for the June-September quarter fell by 26.2% compared with the year-ago period.

But perhaps the biggest problem has been the shortage of dollars. That’s why RBI’s announcement that it stands ready to sell dollars directly to banks and other “entities with bulk forex requirements" is important, as it will ease the pressure on the rupee, because the transaction will be off-market.

Redemption pressures

Here’s another reason why mutual funds and companies faced such a shortage of money in the last few weeks. On 29 August, the investments of all the scheduled banks in instruments issued by mutual funds amounted to Rs22,366 crore, according to RBI data. Six weeks later, by 10 October, that investment had fallen to Rs9,124 crore—a fall of 59% in six weeks. No wonder mutual funds needed to borrow to meet their redemptions.

Rate-sensitive shares

RBI’s policy actions should result in a rise in the prices of the rate-sensitives. Note that while the Sensex went up 12.5% last week, the BSE Bankex underperformed the Sensex, rising by 7.8%. The BSE Auto index too underperformed, going up 8.3%. The star performer among the rate-sensitives was the Realty index which spurted 13.5%, but that’s because it had been beaten down so badly earlier.

Also, while banks will have more resources, does it make sense for banks to lend more? Even if the cost of credit decreases, banks should tighten credit standards to ward off rising levels of non-performing assets. The recent quarterly results of banks have shown a sharp rise in gross non-performing assets for most banks and it’ll be prudent for banks to lower the growth rates for loans in the current environment. And while the extra liquidity should pull down yields, the lower SLR should push up yields on government securities.

The next step

The government, as well as RBI, is attempting to engineer a soft landing for the economy. They are trying to do that by ensuring that there’s enough domestic liquidity to make up for the lack of dollar liquidity. The next step should be to tie up dollar funding.

Admittedly, forex reserves are high, but as a measure of extra comfort the government could easily arrange for a swap line from the Fed, which will inject dollars into the system. Such lines have already been arranged by emerging markets such as Brazil, South Korea, Mexico and Singapore. Note the sharp rise in the Korean won after the swap deal.

Such a deal will improve sentiment and ease borrowing costs overseas for Indian firms. It will mean less RBI intervention in the forex markets and, consequently, less drawing out of domestic liquidity. It will, in short, address the root of the problem.

Graphics by Paras Jain / Mint

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