The Hindu Business Line : The lull before the storm?

The banking system may have no difficulty in absorbing the rise in CRR as it has excess reserves. However, the excess liquidity is not evenly spread across the system. Moreover, the RBI has remained silent on the money multiplier expansion, which the CRR instrument is designed to reduce.

A. Seshan

The policies announced in the Mid-Term Review of the Reserve Bank of India (RBI) are on expected lines. The policy rates have been left unchanged. Only the Cash Reserve Ratio (CRR) has been raised by 50 basis points to 7.5 per cent, effective November 10, 2007.

This was also forecast but it was thought that because of the sensitivities of banks the RBI may make do with just a 25-basis-point increase for the time being.

The banking system may not have any difficulty in absorbing the rise in CRR as it has excess reserves. However, the excess liquidity is not evenly spread across the system. There are banks that are chronic lenders and those which are chronic borrowers in the call money market.

A recent report has it that there is a demand for banks to borrow from the CBLO market at around 5.5 per cent and then park the money with the RBI at 6 per cent to earn arbitrage income on intra-day funds.

This writer had suggested in one of his earlier articles in Business Line that the central bank should examine the possibility of levying an incremental CRR, so that the burden is evenly distributed.

The growth in deposits is not of the same order among banks. The RBI had used incremental CRR in the past. It would appear that this suggestion was made also by some bankers at their meeting with the RBI Governor at the time of the Review meeting.

The substantial increase of CRR by 50 basis points at one time is perhaps designed to forestall the consequences of large capital inflows, in case the US Fed decides to reduce the Federal Funds Rate at its forthcoming meeting in the next two days. But the RBI may have to take further measures if that happens.

Wealth creation

There is a general impression that the Indian markets are the best from the point of view of wealth creation. The continued appreciation of the rupee against major currencies, coupled with rising stock market prices, will be an irresistible attraction to Foreign Institutional Investors to seek opportunities in India for short-term gains.

In particular, the appreciation by 7.1 per cent against yen in the current financial year and the low interest rate at 0.5 per cent prevailing in Japan gives a fillip to the resumption of Yen carry trade, which had a temporary setback when SEBI first announced restrictive measures on the use of Participatory Notes (PNs). Since the issues were clarified the stock market have resumed its upward journey.

The Sensex briefly crossed the 20000-mark and the Nifty is close to 6000. There is some confusion about the objectives of the restrictions.

While transparency in operations and the identification of the ultimate beneficiaries of PNs is, no doubt, the main objective universally accepted, it is not the case with capital flows.

The Finance Minister referred to the need for controlling the unbridled inflows. However, SEBI said that the PN regulations were not intended for the purpose. It is likely that we have not heard the last on the policy statement from the RBI before its next meeting in January.

No changes in rates

The general consensus of bankers seems to be that there will be no changes in the interest rates on deposits or loans consequent to the CRR hike. There has been a trend among a few banks to reduce these rates in recent weeks. Perhaps this trend may be arrested. Since bank credit appears to have picked up there is no immediate need to reduce rates in the context of the rise in interest-free CRR.

Commentators have made the point that considering the massive increase in deposits, the siphoning off of about Rs 15,000 crore will not make any difference to the system.

What is forgotten is that the instrument of CRR is designed to reduce the Money Multiplier (MM), i.e., the multiple by which an original injection of deposits can lead to a multiple expansion in the system over a period of time.

At the current CRR level the MM is estimated to be 4.74, keeping in view the currency-deposit ratio, CRR and excess reserves of the banking system. It will get reduced. A year ago it was 4.95. Surprisingly, the RBI keeps silent on the trends in the MM. In the past, analysis had been made in this area in other publications, though not in the monetary policy statements. One hopes that in deciding on the extent of changes in CRR the Bank takes into account not only the absolute amount impounded immediately but also its impact on the working of the MM.

The rationale

In his usual lucid way Governor Reddy explained the rationale for the major policy measures. Growth of Gross Domestic Product is on track.

What is more heartening is the quality of growth. Capital goods production and their imports are on a rising graph. Non-food credit has plateaued to the level desired by RBI. Inflationary trends are also not alarming.

The current account deficit is manageable. If the Government sticks to the Budget estimates, the RBI has no problem in carrying on with its existing policy stance.

The major problem confronting the country is the excess liquidity introduced into the economy by the external sector.

He referred to the unusual response of central banks in the West, in contrast to historical experience, in dealing with the sub-prime mortgage crisis. It was not on conventional lines and has led to a large rise in global liquidity. Its repercussions on India cannot be predicted, as of now.

Another area of concern is the increasing trend in oil prices, which are yet to be passed through, and in commodity prices in the international markets.

onetary policy will have to address not only the liquidity overhang but also incremental flows in the future, if they continue at present levels.

(The author is a former officer-in-charge of the Department of Economic Analysis and Policy, RBI.)

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