Don’t bank on just rate cuts: Financial Express, 17th April 2012

Since banks earned more from CRR cuts than from a 100 bps repo cut, they could have lowered rates even last year

The second biggest event in the economic calendar is the annual credit policy announced by RBI. Coming as it does after the Budget, it tells us some very important economic hopes or forecasts (one is not sure which one it is) and the monetary targets that are consistent with these numbers. There is no clear pattern on whether RBI’s GDP and inflation numbers for the year are lower or higher than what is implied in the Budget, but the language is generally similar. RBI tends to be a bit more conservative and it would be interesting to see, in case they pitch for 7.5% growth à la Union Budget 2012-13 or settle for something lower. Implied inflation in the Budget was in the 6-6.5% range, and it looks like that our new standard for inflation would be at this higher level. This means goodbye to the utopia of 4 or 5%, which we spoke of in the last 2 years.

Past annual policies have targets for money supply, credit and deposits growth and normally vary between 15-18%. In the given circumstances, there is no reason to expect RBI to target something higher given that the fundamental underlying conditions have not changed significantly. Deposits have not grown at the desired rate for two successive years, ostensibly due to higher inflation, which caused households to save less despite rising interest rates. The question is how do we raise our savings? So far, due to lower economic growth, demand for credit has been relatively tardy. But, once there is a pickup in credit, there would a mismatch between deposits and credit. Add to this the demand from the government, and there will be liquidity problems. RBI should address this issue with some expediency because the efficacy of policy will hinge on this variable.

What can be the content of the policy? There are several recommendations being made by companies, bankers, experts, etc, on what RBI should do. If one is in the private sector, the vote is for interest rate reductions (even though we personally take a hit on our savings), while the academics are more open to protecting one from inflation by using the real interest rate argument. Clearly, RBI is aware of the pros and cons of either lowering or not changing the repo rate or the CRR. Therefore, what RBI does will be more a reflection of how it perceives the state of growth and inflation; and its revealed preference will set the tone for the year.

Growth is down for sure and there is merit in lowering rates. But RBI has followed the path of combating inflation, and doing a volte face now looks unlikely unless it is sure that inflation will stay at the lower pre-determined level, of presumably 6-6.5%. The repo rate is a signal rate of RBI’s action, and hence, cannot be altered in the reverse direction if inflation moves up again. The upside risks exist on the side of oil as well as taxation effects. The monsoon is still an unknown quantity and lower interest rates at a time when we do not have spare capacity can be inflationary if too much credit is enabled.

Curiously, RBI had contended that the CRR cuts were viewed as liquidity enabling measures rather than monetary policy measures. This is not what the conventional textbook says. This being the case, CRR cuts can be persevered with to signal to the market that liquidity will be provided to take care of requirements of banks as well as the government—the borrowing programme will move easily.

The reaction of banks so far has been puzzling. Banks today maintain that a CRR cut will enable them to lower interest rates. However, when RBI has done the same last fiscal, we had around R80,000 crore provided to the system. Yet, banks did not lower rates. In fact, the CRR cut is potentially a stronger tool for lowering interest rates. This reduction would have provided banks with a minimum of R8,000 crore of extra income if lent at 10% as against nil on CRR. Compared with this amount, a repo cut of 100 bps on an annual daily average of R100,000 crore provides relief of just R1,000 crore. Therefore, banks could have actually lowered rates if they wanted to with this transaction.

As monetary policy has to be forward looking, it probably makes sense to actually wait for inflation to ease before reducing rates. A CRR cut, though not essential during the slack season, would help in assuaging liquidity. A thought that is not really novel is whether RBI should restrict the quantity of repo auctions just like how we have WMA limits. This can add a bit of dynamism in the call market too, which would become volatile as currently mapping where this repo money goes on a virtually permanent basis is still a matter of conjecture. More importantly, one should not get carried away by over-emphasising the role of interest rates in spurring growth as other elements such as consumption demand, government spending and exports are important pieces in the puzzle, of which we are holding just the investment piece in our hands.