Home >Opinion >Rate cut can wait, liquidity is a bigger issue

In the September 2015 review of monetary policy, the Reserve Bank of India (RBI) surprised the market by cutting its policy rate by half a percentage point to 6.75%. It had also said that its stance would “continue to be accommodative".

In the next policy review in December, the central bank kept the rate on hold with a promise to cut it in future, saying it would “use the space for further accommodation, when available".

Has this space been created? Will RBI go for a rate cut on 2 February?

Let’s first see what all have changed since the last policy announced on 2 December.

First, as was expected, the US Federal Reserve raised its short-term interest rate in mid-December, for the first time in a decade. Second, the price of the Indian basket of crude oil, which was a little over $40 a barrel in the first week of December, has now dropped below $25 a barrel, its 13-year low. And it’s not the oil price alone. Prices of other commodities such as iron ore, aluminium, steel, copper, platinum and palladium have also collapsed. Finally, the global growth prospects have turned gloomier.

What do all these mean? The combination of the collapse of commodity prices and weaker prospects of economic growth has created more room for cutting rates. The onshore swap markets are expecting around 30% probability of a quarter percentage point rate cut on Tuesday even as most analysts in India think the status quo is par for the course.

It’s fairly certain that there will be at least another round of rate cuts and the policy rate will come down to 6.5%, but the question is whether RBI governor Raghuram Rajan would like to do it now or after the Union budget is presented at the end of this month.

While the wholesale price inflation continued to remain in the negative, the retail inflation rose to 5.61% year-on-year in December from 5.41% in November, higher than what most analysts had expected. Food price inflation quickened to a 10-month high of 6.4% in December (from 6.1% in November), while the so-called core inflation (minus petrol and diesel) remained unchanged at 5.4%.

Theoretically, every $10 drop in a barrel of crude should take away a quarter percentage point from retail inflation, but the destruction in commodity prices is unlikely to have an overwhelming effect on inflation as the consumers don’t get the entire benefit because of the hike in excise duty and an anti-dumping duty to protect the domestic producers negate the benefit of lower commodity prices. Besides, food inflation, which has around 46% weight in retail inflation, will continue to depend on the trajectory of the monsoon and the government’s minimum support price for food grains. It seems that RBI’s projection of below 6% retail inflation in January will be met, but bringing it down to 5% by March 2017 will not be easy.

Meanwhile, factory output contracted 3.2% year-on-year in November from 9.9% growth in October, significantly lower than consensus expectations. Since Diwali holidays were in November in 2015 (and in October in 2014), moderation in factory output was expected because of the unfavourable base effects, but the level of contraction, primarily due to slower growth in capital goods output growth, was not anticipated. This and the continuous slide in exports because of the global slowdown tell us that the domestic growth story is running the risk of losing its momentum and another round of rate cuts may just give it a fillip.

However, Rajan is likely to wait for the Union budget to be presented. In the first three quarters of 2015-16, India’s fiscal deficit remained at 87.9% of the full-year target, signalling better fiscal management.

It is fairly certain that for the current financial year, it will be kept at 3.9% of the gross domestic product, but will the government be able to stick to its target of keeping it at 3.5% in 2017? There will be challenges in the form of the impact of the hike in wages of government employees following the recommendations of the Seventh Pay Commission. Besides, the hike in excise duty has helped the government mop up money this year, but with inflation being tamed, the nominal GDP growth will be less next year and hence the kitty will not swell as much. Also, a volatile equity market is not ideal for the government’s disinvestment programme.

The mid-year economic review by the finance ministry has suggested revising upward the fiscal deficit target of 3.5% of GDP set for next year to boost investment in infrastructure. Many believe that instead of paring it to 3.5% of GDP, the fiscal deficit can be kept unchanged at 3.9% (target for fiscal year 2016), as even at this level, it is below the 4.8% average of the past 16 years since 2000.

However, this may not cut ice with Rajan. He would probably want to be convinced that indeed the government is on the fiscal consolidation path before going in for a rate cut, probably the last, till clarity emerges on the course of the monsoon and food inflation. The Australian Weather Bureau’s prediction that El Niño conditions will fade over the next few months and the return of normalcy by June may pave the path for more rate cuts in the second half of the year if inflation maintains its current trajectory.

At this point, more than a rate cut, tightness in liquidity is a major issue for the Indian banking system. The daily liquidity deficit is around 1.5 trillion and the average deficit in the past six weeks has been around 1.35 trillion. Officially, RBI’s level of comfort for liquidity shortage is 1% of the banking system’s net demand and time liabilities, but this has been far higher for many weeks now.

There are many reasons behind this. In the past, between 2009 in the wake of the collapse of US investment bank Lehman Brothers Holdings Inc. and 2012, RBI had been pumping rupees into the system, buying bonds from the banks through the so-called open market operations or OMO. From 2013 till last year, the central bank was buying dollars from the market and adding to India’s foreign exchange reserves. For every dollar it had bought, an equivalent amount of rupees flowed into the system.

With the local currency depreciating, RBI is no longer buying dollars and hence the flow of rupees has stopped. In fact, it has been selling dollars, although in small quantities. This sucks out rupees from the system. Besides, the government has not been spending as much as it should (its cash balance with RBI was 1.4 trillion last week), and for some reasons, currency with the public or the money in circulation continues to remain high even now. Typically, this happens during festivals such as Diwali.

Indeed, RBI has been doing OMOs and also buying bonds directly from the market, but that has not been enough. As a result of the liquidity shortage, monetary transmission has been hampered. The banks are not willing to cut down their deposit rates for fear of running short of resources. They are also conservative in buying bonds. The yield on 10-year benchmark paper has virtually remained unchanged in the past many months despite successive rate cuts even as at the shorter end—two-year and five-year bonds—yields have dropped.

So, RBI needs to be more aggressive in buying bonds. And, as a permanent measure of infusing liquidity, it needs to pare banks’ cash reserve ratio (CRR) of the portion of deposits that commercial banks are required to keep with the central bank, sooner than later.

RBI can make a token quarter percentage point cut in CRR and bring it down to 3.75%. This will release about 23,000 crore into the system. Apart from augmenting resources, a cut in CRR also adds to banks’ profits as they do not earn any interest from the deposits kept with RBI.

Another big issue staring at the banking system is the 4.3 trillion debt restructuring of power distribution companies or discom under the Ujwal Discom Assurance Yojana or UDAY. Three-fourths of the debt is to be converted into bonds, backed by state government guarantees and half of this is expected to happen before the fiscal year-end. One of the reasons why the yield on 10-year paper is not coming down is the oversupply of bonds. This will also affect the government borrowing programme next fiscal year and this is why the government should stick to the fiscal deficit target.

While the conversion of discom loans into bonds will spare the banks from the pain of rising bad assets, it will hurt them at the same time as their loan books will shrink and, because of this, by simple arithmetic, the percentage of bad loans will rise. The banks will also run the risk of booking so-called mark-to-market losses on these bonds in case of any adverse trend in interest rates.

They only way to protect them from such losses is allowing them to keep these bonds in their books under the so-called held to maturity or HTM category, a status that only the government bond enjoys. RBI can give this status to infrastructure bonds with at least seven-year maturity. To make the UDAY scheme a success, the central bank may have to do this.

An even bigger problem for the banking system, particularly the state-owned banks that hold more than 70% of market share, is bad assets, their recognition and setting aside money for them. The monetary policy is not the platform to address this; we will have to wait for the budget.

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

His Twitter handle is @tamalbandyo

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