The Hindu Business Line : Rates are right, liquidity is not

The quarterly monetary policy review was awaited with the same angst as any annual policy. The reason is simple. In the past several weeks, interest rates in the interbank market for overnight money have plunged to near zero. Will this abnormal state of affairs continue? More important, will the RBI tolerate it? These were the things bothering the market.

The central bank has been trying to make money dearer for some time now. Its stance was nullified by robust Government spending in the new financial year and forced intervention to support the dollar, both of which have created enough and more liquidity in the banking system, resulting in artificially low money rates.

Surplus liquidity

Excess liquidity doubtless has the potential to spill over into prices (although current inflation reckoned on wholesale prices is down to 4 per cent+ levels from over 6 per cent. The RBI has a range of choices to remove surplus liquidity — increasing the Cash Reserve Ratio (CRR), issuing more Market Stabilisation Scheme bonds or absorbing it in the daily reverse repo auctions.

Each of these has its own advantages and disadvantages. While a CRR increase imposes no costs on the RBI, it constricts banks’ ability to lend, apart from hurting their profits.

MSS bonds are a costless option for the RBI but not for Government which must pay interest on them but has no access to the bond issue proceeds. Mopping up liquidity through reverse repos imposes the servicing costs on the RBI.

Mix of CRR weapon

In the quarterly review, the central bank has opted for a mix of the CRR weapon — the CRR is up from 6.5 per cent to 7 per cent — and increasing liquidity absorption through reverse repos by doing away with the Rs 3,000 crore cap on reverse repos. It has left the repo rate unchanged clearly suggesting its worry is not the cost of money but the flood of liquidity.

What will be the impact? The 0.5 per cent increase in CRR will impound Rs 25,000-30,000 crore. Will money rates shoot up? Offers to the RBI in reverse repos have been running at Rs 50,000 crore upward (although there is talk of inflated offers to maximise individual banks’ allocations). Still, the phenomenon of zero rates indicates there need be no alarm on the liquidity front.

The RBI may have succeeded in arresting asset price inflation of the property variety, at least for the time being, by inducing sufficient fear and uncertainty in the market. The remaining worry is energy, for the good monsoon will keep primary article inflation in check. If, as seems probable, energy prices fall significantly, the economy is poised to forge ahead with inflation worries relegated to the backburner.

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