The Hindu Business Line : A sensible policy, on expected lines

With the Government having worked out its spending surplus and drawing on the advances with the RBI, the only imponderable now is the outlook for foreign capital inflows.

A. Seshan

The Reserve Bank of India’s first quarter review of its Annual Policy Statement has turned out to be on the expected lines. In the preview article it was foreseen that policy rates — the Bank Rate, the Repo Rate and the Reverse Repo Rate — would remain unchanged but the Cash Reserve Ratio (CRR) may have to go up in the context of the enormous growth in Reserve Money (“A pause in policy rate changes?”, Business Line, July 30 ).

The RBI has raised the CRR by 50 basis points to 7 per cent at one stroke, effective August 4, unlike in the past, when such hikes were in two instalments of 25 basis points each, to facilitate a smooth transition by banks to the new rule.

This is understandable, when seen against the need for urgent action. Reserve Money, or High-Powered Money, recorded an annual growth rate of 29.1 per cent, as on July 20, in contrast to 17.2 per cent a year earlier. This spells potential trouble in the not-too-distant future on the money supply and inflation fronts.

In fact, it has already registered the damage with the broad measure of money supply registering a growth rate of 21.6 per cent, as on July 6, against 19 per cent a year ago, and the central bank’s target of 17-17.5 per cent. Just as the Money Multiplier (MM) takes time to work out its expansion, it has also a lagged effect in effecting a deceleration. Commentators on TV channels have referred to the withdrawal of Rs 15,000 crore from the system due to the rise in CRR.

This is a small amount in relation to the total money supply of Rs 34,34,643 crore, as on July 6. But actually it is much more. The money multiplier is around 5.

Thus, the medium-term impact is a deceleration in the growth of money supply by as much as Rs 75,000 crore. This is the amount one sees the banks offering the RBI for reverse repo operations on occasion, even though unsuccessfully so far due to the cap of Rs 3,000 crore. Thus, the impact of the 50-basis-point rise in CRR at one go will register its impact on money supply growth, ceteris paribus.

Important caveat

The last-mentioned caveat is important for the reasons discussed below. One does not understand why the RBI fights shy of the incremental CRR, which it employed in the past on several occasions. It ensures inter-bank equity in the distribution of the underlying burden.

Will the change in CRR really result in a substantial deceleration of the growth in money supply? In the past, both the spending by government of its cash surpluses and massive injection of capital from abroad contributed to easy liquidity conditions. But now, the Government has worked out its surpluses in spending and is drawing on its Ways and Means Advances with the RBI and has even resorted to overdrafts. Thus, the only imponderable in the situation is the outlook for foreign capital inflows.

In addition to keeping the reverse repo rate unchanged at a relatively high 6 per cent vis-À-vis other developed countries and removing the cap of Rs 3,000 crore on its operations, the central bank might have only provided a do or for further inflows seeking arbitrage opportunities through carry-trade.

Thus, while the RBI is right in raising the CRR to tackle excess liquidity, it may perhaps be caught on the wrong foot by the removal of the cap on reverse repo operations.

Perhaps, the RBI is aware of its being caught in the deluge of forex inflows and the consequent sterilisation operations. Hence, it has retained the discretion to re-impose the ceiling as appropriate.

Implications of higher CRR

What does the rise in CRR mean for interest rates? Neither the RBI nor commentators have referred to excess reserves in the form of bankers’ deposits with the RBI. As of July 6, it amounted to 1.4 per cent of deposits. This is not small, as the base is large.

Thus the system can easily absorb the additional 50 basis points without much difficulty. This also justifies the one-time implementation of the hike. Of course, within the system the impact will differ from bank to bank depending upon its reserve position and standing in the call money market, as a borrower or lender.

Banks such as the State Bank of India and Canara Bank, regular lenders in the Call Money Market, will benefit by their ability to deposit larger amounts with the RBI than they have done since March, when the cap of Rs 3,000 crore was introduced.

There is no case for them to raise the lending rate. But, as pointed out in an earlier article by this writer, even for others, there is likely to be no increase in lending rates, of the kind seen in the past whenever similar hikes in CRR were effected.

Given the excess liquidity, some banks have already announced cuts in deposit rates at the short end without any corresponding decline in lending rates.

Thus they may be able to maintain their spreads in the new situation instead of increasing them, which they would have otherwise. Since there is already a palpable declining trend in lendings, banks may not like to raise rates.

If the RBI really pursues its reverse repo operations on a massive scale the easy conditions seen in the call money market may not prevail in the future.

Their rates may be restored to the normal position, falling between the policy rates prescribed by the central bank. The decline in deposit rates at the short end without changes in the rates for deposits of one year and above should contribute to a better matching of assets and liabilities, which is essential for the banking system. It may even contribute to a better performance on the term-loan front, mainly for investment purposes.

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy of the Reserve Bank of India.)