The Hindu Business Line : May both Govt and RBI win!

Rumours started swirling around about a fortnight back. They became fact late last week when the Government issued an ordinance enabling the Reserve Bank of India to vary the Statutory Liquidity Ratio (SLR) - the proportion of deposits that banks must invest in sovereign bonds - depending on its assessment of financial conditions from time to time.

It was not as if the RBI was asking for it. The central bank's concern in recent months is that the economy is growing too fast for its own good. Reflecting this, it followed up a 25bps hike in the repo rate in late-October with an increase, soon after, from 5 per cent to 5.5 per cent, in the cash balances (CRR) that banks must maintain with the RBI. The idea was to shrink system liquidity, reduce lending capacity and make borrowing costlier.

Drops a hint

Giving the RBI the freedom to change the SLR is a none too subtle hint from the Government to cut it so that banks can swap (obligatory) investments for credit to meet the needs of the rapidly-growing economy. That precisely is the point, says the central bank - we are running into capacity constraints and credit expansion will only stoke inflation. Should monetary policy, in these circumstances, be accommodative?

It is now clear that increasing interest rates in baby steps has no effect. What matters in the ultimate analysis is system liquidity. This became obvious in the aftermath of the mid-term review of monetary policy when markets greeted the repo rate hike with a yawn and drove down money rates and bond yields, but sat up when the CRR rose 50bps. Reaction was swift. The cost of overnight borrowing jumped and bond prices dropped - precisely what the RBI wanted. It is difficult to think of a more effective (and blunter) instrument.

Existential fix

The Government is caught in an existential dilemma, hemmed in, as it is, by the FRBM (Fiscal Responsibility and Budget Management) and fiscal goals, which constrain it from spending and creating liquidity. The RBI too is in a cleftstick - it does not like the explosion in bank lending and soaring real estate prices, which are not captured in the price index, but are, somehow, in an indefinable way, worrying. Asset price behaviour calls for punitive interest rates, but, in monetary policy-making, one can't compartmentalise this from the rest of the economy where prices are `well behaved'.

An SLR cut by itself will do nothing for liquidity but increase gilt yields (as has already happened). Liquidity is bound to tighten in coming times, with interest rates moving up all along the curve.

An interesting sidelight is the marked difference in what keeps the Finance Minister and the RBI Governor awake at nights. For the Finance Minister (naturally), growth takes precedence over inflation, while, for the central bank chief (as, indeed, for all of them), inflation is the bigger enemy.

May both win!

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