The Hindu Business Line : Who will take the lead in cutting rates?

Recent developments in the money/forex market are turning out to be knotty for commercial banks and call for an early RBI intervention. These developments suggest that interest rates may have to come down and quickly at that.

T. B. Kapali

Neither commercial banks nor the Reserve Bank of India seems to be ready or keen on doing anything immediate about interest rates. The RBI has slated its Quarterly Monetary Policy Review for July 31 and is keeping off the markets for the time being.

It probably does not feel that the prevailing money market situation (with inter-bank rates sub-1 per cent for a considerable period now, from around early June) is abnormal enough for it to consider any kind of inter-meeting moves, even if they be only public comments.

Scheduled commercial banks, in the absence of any signaling by the RBI, are not prepared to take the plunge in formulating and implementing an interest rates stance.

Therefore, the spectacle of inter-bank call money rates ruling ultra low, at around 0.40 per cent for some time now.

Adding to this is the dollar going into a discount (for maturities up to three months) in the forward foreign exchange market.

As the Table shows, from a premium of around 5 per cent early in May, the one-month forward dollar had gone into a discount of as much as 2 per cent as of July 23.

The premium for the other maturities up to 6 months has also come down quite sharply. The steep decline in the forward dollar rates has coincided with the ultra soft tone in the inter-bank money market the past couple of months.

Liquidity not due to RBI

The article “Interest’ing climb down ahead” (Business Line, July 20) had shown that the current situation of surfeit liquidity in the money market has not been caused by the creation of base (reserve) money by the RBI. The central bank’s foreign exchange market intervention — to buy dollars — has slowed considerably between April and now.

The money market is awash in liquidity more due to a noticeable slow down in credit growth whereas deposit expansion has sustained the momentum noticed four-five months ago. Banks are unable to deploy the mobilised funds at the prevailing levels of interest rates.

Given this broad scenario of a slow down in asset creation, we had surmised that the RBI may not guide the rates (up or down) for now as its actions are not the proximate cause for the prevailing easy money market environment.

We indicated that the RBI may well make no change in its (policy) rates on July 31 and could leave it to the banks to work down the money market surpluses through actions on the borrowing and lending sides of their balance-sheets. Also, the possibility of the RBI leaving the Cash Reserve Ratio unchanged (as long as the softening trend in the wholesale price indices sustained) was indicated.

Banks not ready to take a stand

As things stand, commercial banks do not seem ready to exercise the discretion conferred on them by the RBI.

There have been no moves (down) on their deposit or lending rates though industry players have gone on record that rates have peaked. But banks also realise that it is not optimal at all to carry such high levels of liquidity on their balance-sheets for long periods. They must earn at least something more than the sub-1 per cent returns available in the money market.

So, where is all this liquidity being parked? In overseas dollar money market investments at rates of interest around 5.30 per cent. This is the reason for the steep fall in the dollar’s forward premium in the domestic foreign exchange market.

Banks use the rupee liquidity to purchase dollars and park them in overseas money market investments. They are making sure they have rupee liquidity at the maturity of these (overseas) investments by contracting to sell the dollars forward. This depresses the dollar’s forward rate.

The whole transaction is basically in the nature of a rupee lending (and for the counter party bank it is a rupee borrowing transaction, much like a securities repo) so that the foreign exchange rate does not get affected at all. Banks which borrow rupees through this forex route get funding at very attractive rates.

As the dollar premia (discount) remain at these levels, the funding costs through this route could be as low as or even lower than the rates obtainable in the local call money market.

Direct quantum limits also are applicable in the case of call money borrowings. Quantum limits also operate indirectly in the case of rupee funding generated through the forex route.

The amount lent/borrowed through the forex route would be constrained by the overall foreign exchange limit, which is approved for each bank by the RBI. And it would also not be advisable for any bank to fund any asset position in a sustained manner through this “synthetic” rupee route.

Overall, the recent developments in the sub-segments of the money/forex market are turning out to be knotty for commercial banks and possibly call for early RBI intervention.

These developments do suggest that interest rates in India may have to come down and quickly at that.

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