Don’t read too much into feel-good SLR cut


A one percentage point cut in banks’ investments in government bonds, lowering the floor for such holdings from 24% to 23%, is a surprise, particularly when the government is set to borrow a record Rs.5.7 trillion from the market to bridge its projected fiscal deficit, equivalent to 5.1% of gross domestic product.
At this point, however, it is purely an academic exercise as the banking system’s average government bond holdings are around 30.5% of their deposits, 6.5 percentage points higher than what they are holding.
So a cut in their bond holding requirement is unlikely to free any money in banks’ coffers, which can be used to meet corporate credit demand. A one percentage point cut in the requirement theoretically frees up around Rs.62,000 crore.
Why did the Reserve Bank of India (RBI) cut banks’ statutory liquidity ratio (SLR), or the percentage of deposits that banks are required to invest in government bonds? One explanation could be that RBI governor D. Subbarao is extremely serious about the central bank’s fight against the government’s fiscal profligacy. RBI has been repeatedly stressing the limitations of monetary policy and wants the government to get its act together to fight a persistently high inflation and ensure sustainable growth. Cutting down SLR is another salvo as it will discourage banks from buying government bonds and push up yields, forcing the government to pay more for its borrowing. In fact, after the policy announcement, bond yields did rise and prices fell.
But the effect is unlikely to last long as RBI continues with its so-called open market operations and buys bonds. This will ensure liquidity and prevent bond yields from rising too much. Through its bond buying, RBI infused Rs.82,600 crore into the system in the first quarter of the current fiscal.
If it’s not an action to teach the government a lesson, what else could have prompted RBI to cut SLR? Possibly, to create a cushion against any liquidity tightening later that can happen if RBI aggressively intervenes in the foreign exchange market to protect the local currency. Till now, RBI has been very active in the forwards market and selling very little spot dollars to avoid draining liquidity. For every dollar it sells, an equivalent amount of rupees leave the system. Besides, there will be pressure on liquidity in the second half of September, when Indian corporations pay advance income tax for the quarter.
Banks use their excess government bond holdings as collateral to borrow money from RBI’s repo window. Although the system as a whole has much higher bond holding than is required, a few banks—foreign and small private banks—do not have too much leeway as their SLR holdings are just marginally more. They will benefit from the move as with a lower floor for SLR, they will have excess bond holdings against which they can borrow from the repo window.
Theoretically, even larger banks will have the option of liquidating their government bond portfolio and using the money to lend to the private sector following the cut in SLR. At this point, however, it is nothing but an academic exercise as banks are comfortable with investing in zero-risk government bonds and most of them are consciously staying away from lending to private firms, fearing a rise in bad assets.
More than the cut in SLR, the highlights of RBI’s first quarter monetary policy is paring the growth projection, from 7.3% to 6.5%, and raising the year-end wholesale inflation projection from 6.5% to 7%.
The rise in the inflation projection diminishes the chances of rate cuts this year. Till now, most economists and analysts have been talking about a 50-75 basis points (bps) rate cut in the second half of the year, but after this they will possibly go back to the drawing board and rework their rate cut projections. A basis point is one-hundredth of a percentage point. If indeed inflation rules at 7%, how will RBI be able to cut the rates?
It will be able to cut rates only if the economic growth declines further, goes down even below 6.5%. Or if inflationary expectations go down drastically.
At this juncture, RBI doesn’t seem to have too many options. It had frontloaded rate cuts in April by going in for a deep 50 bps cut. Now the ball is in the government’s court. It needs to commit itself to fiscal correction, stimulate the investment climate by taking policy decisions and create space for the monetary authority to act. The SLR cut now at best creates a feel-good effect and nothing more—it’s the best that Subbarao could do in the worst of times.

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