The equity market and, to some extent, the bond market are giving the thumbs down to the Reserve Bank of India’s (RBI) first bi-monthly monetary policy of the new fiscal year simply because the Indian central bank has cut its benchmark repo rate by only a quarter of a percentage point to 6.5%, something the markets had already factored in.

Since the RBI has not cut its policy rate by half a percentage point or combined the quarter percentage point rate cut with a cut in banks’ cash reserve ratio, or CRR, market participants are interpreting it as a non-event.

CRR is the portion of deposits that banks keep with the RBI on which they don’t earn any interest. A cut in CRR releases money into the system.

The RBI has, through a significant change in its stance on liquidity, more than compensated for limiting the rate cut to the expected quarter of a percentage point. In the long run, this structural change will ensure better transmission, something which a deeper rate cut could not have done.

Here is why:

First, the RBI is shifting its stance from a banking system with a 1% deficit of the so-called net demand and time liability or NDTL (loosely, a proxy for deposits) to a position “closer to neutrality". Even though, the stated position has been keeping the system at a 1% deficit mode, in reality, the deficit has been much higher. The average liquidity deficit in past three months has been at least 1.5% of NDTL.

Second, the so-called interest rate corridor between the repo rate (or the rate at which banks borrow from the RBI) and the reverse repo rate (or, the rate at which banks park their excess money with the RBI) has shrunk from 1% to 0.5%. Banks will now borrow from RBI at 6.5% and keep excess money with the central bank at 6%.

This means they will earn a little more than what they were earning before as and when they have excess resources. But more important than that, it will change the entire interest rate architecture in Indian banking system. How? In the current regime, since the system has always been in a deficit mode and the banks were borrowing money from the RBI, the operative rate has been the repo rate. Till Monday, banks were borrowing overnight money from RBI at 6.75% and term money at 6.85-9%. Now, if the RBI sticks to its promise and keeps the system in near-neutral mode (this means, I presume, sometime in excess too), the banks will not be required to borrow money from the central bank. So, the effective rate will be the reverse repo rate or the lower end of the corridor—6%.

Now, how will the RBI keep the system near-neutral and ensure durable liquidity? RBI governor Raghuram Rajan has not answered this question. But definitely not by cutting CRR. A half a percentage cut in CRR at this point would have released around 47,000 crore into the system. By going in for a structural change, Rajan has actually ruled out a CRR cut anytime soon. And, by announcing 15,000 crore bond buying through the so-called open market operations, or OMOs immediately after announcing the policy, he has hinted that OMOs will be the preferred route for liquidity injection. With the local currency strengthening, RBI may also start buying dollars from the market and as and when that happens, rupee resources will flow into the system and add to the liquidity.

Will we see the effect of the structural change immediately in the market? Certainly not. It will be a work in progress. Banks will continue to borrow from the RBI for the time being and it may even take a couple of years to achieve the desired results. The RBI is aware of that but this also means that barring unforeseen external developments, the Indian central bank will continue with its accommodative stance for the next couple of years. Had Rajan not been reasonably confident on this, he would not have launched these structural changes at this juncture and, instead, gone for an easy way out—a cut in the CRR.

There are a couple of other measures too to iron out the liquidity glitches. For instance, the RBI has brought down the limit of daily cash balance that banks need to keep with it for CRR from 95% to 90%, allowing them to keep more money with themselves. Also the interest on the so-called marginal standing facility, or MSF, has been cut by three quarter of a percentage point to 7%. Banks borrow from the RBI at the repo rate, offering government bonds as collateral. When they don’t have enough bond holdings and need to dip into their statutory liquidity requirement, or SLR (currently 21.25%), holdings to offer as collateral to borrow from the RBI, they need to pay the penal rate of MSF. SLR is the proportion of deposits that banks need to invest in government bonds.

All these measures will ensure better monetary transmission. In fact, the marginal cost-based lending rate, or MCLR, to which the Indian banking system had shifted on 1 April has already brought the loan rate by about a quarter of a percentage point. The latest round of rate cut will translate into a cut in MCLR when most banks review their loan rates on 1 May. The cut in the small savings rate by the government will also encourage them to pare their deposit rates. While an MCLR review will take place in May, banks may start cutting their deposit rates this week itself.

When do we see the next round of rate cuts by the RBI? Since January 2015, when the accommodative cycle started, the central bank has cut its policy rate by 1.5 percentage point. I would not expect yet another rate cut any time soon—certainly not in June when it announces its next bi-monthly policy.

Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of Sahara: The Untold Story and A Bank for the Buck.

Comments are welcome at bankerstrust@livemint.com. His Twitter handle is @tamalbandyo.

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