A Credit policy like never before: January 22 1011 Financial Express

Even though we have a credit policy review every second month, the one to be announced on January 25 will be special for several reasons. There are basically going to be four takeaways—two operational issues for banks and two for the general public, too.

Currently, the situation is full of contradictions. There is a liquidity problem with credit growing faster than deposits. Inflation is high on account of supply shocks that were not anticipated. Industry is doing well on a cumulative basis, though monthly performance is disturbing, with high growth rates alternating with low ones. Exports are booming but the current account deficit is a worry. Tax collections, especially indirect taxes on goods, have been robust, which means lots of things are happening. FII inflows, which were gushing in a couple of months back, have now stagnated, and the rupee is depreciating as against appreciating earlier. Capital issues are up, as are debt issuances, but the stock market remains whimsical with inflation and possible RBI action dominating sentiment. The question is how RBI would react to this situation.

The government has given up on inflation and passed the baton to RBI, which means that RBI is expected to increase interest rates, which it will. Higher interest rates cannot produce goods but it can reduce other demand for goods and investment. By increasing interest rates, RBI can lower the demand for credit that can be deferred, which affects households through, say, mortgages and auto finance. Simultaneously, deposits would increase, thus lowering the liquidity deficit. How much should RBI increase interest rates? Ideally, 50 bps will work, but given that RBI has followed a gradualist approach, 25 bps looks more likely on both the repo and reverse repo.

What about liquidity? In the last policy, the liquidity position was acute, with over Rs 1.3 lakh crore going into repos every day. RBI chose to lower the SLR and announced OMO purchases for Rs 48,000 crore. But this has not really helped as banks are still resorting to borrowings of Rs 1 lakh crore a day from RBI through the repo auctions. The answer is hence in lowering the CRR. But, lowering CRR is contrary to increasing interest rates in the strict sense as more liquidity actually lowers rates. But in the current situation, where liquidity is very tight, this may not happen. Also, if RBI believes that for two problems we need two instruments, then these two moves can be synchronised and may not be contradictory. Therefore, a CRR cut may not be out of sync here as it will release around Rs 25,000 crore into the system. There is otherwise little that RBI can do to augment liquidity. Further OMO purchases could be persevered with but then one is not sure of the result. Probably a combination of higher rates which slows down credit and CRR cut would work in unison to ease liquidity.

The other two areas of interest is RBI’s take on growth and inflation. So far, we have all been sanguine on growth as the first half GDP number has been 8.9%, with an upside being believed for the remaining half. However, industrial performance has been volatile this year so far and hence RBI’s revised target would be of interest. Higher interest rates, it is argued, have a negative impact on industry as investment is postponed. But the counterview is that higher rates make industry manage their inventory in a more efficient manner and also use capital more judiciously. As long as demand is there, investment will carry on. Today, households are spending more on account of inflation and not really cutting down on such activity while savings are being affected as seen in the tardy growth in deposits. Hence, while there are arguments on both sides, the final call guidance from the central bank would be instructive.

Inflation is another parameter for which one would be looking for guidance. It is generally believed that inflation will end up over 7% this year by March and probably be in the 8.5-9% on an average for the year. RBI will evidently have its own impact analysis in place to gauge the effect of another round of interest rates on the inflation number. Hence, RBI’s call on inflation will not just give us the official picture but also indicate further policy action, especially if it varies significantly from the existing trends.

Hence, this policy statement of RBI will be very critical and the market will surely read the words carefully to take hints about future scenarios.