There are no prizes for guessing what Reserve Bank of India (RBI) governor Raghuram Rajan will do on 30 September when the central bank announces its monetary policy. He will not cut the policy rate. The wait will be longer for those who have been clamouring for a rate cut despite the fact that wholesale price inflation in August slowed to a five-year low of 3.74%.
In his last policy in August, Rajan had left the key rate as well as banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with them, unchanged, but cut banks’ mandatory investment in government bonds, or the so-called statutory liquidity ratio (SLR), by half a percentage point to 22%, a repeat of what he had done in June. It will be interesting to see whether he will go for a cut in SLR this time too.
Indeed, helped by a favourable statistical base and falling global crude oil prices (which have dropped to a two-year low), India’s wholesale price inflation dropped sharply in August but it is unlikely to have any impact on RBI’s policy decision. The central bank takes into account retail, or consumer price, inflation, which slowed marginally to 7.8% in August from 7.96% in July. RBI wants to keep retail inflation below 8% by January 2015 and 6% by January 2016. It may not be difficult to achieve the first milestone, but paring retail inflation to 6% by January 2016 is not an easy task, primarily because of persistently high food inflation, which has close to 50% weightage on retail inflation.
In August, food inflation quickened to 9.42% over 9.36% in July. For argument’s sake, if food inflation continues to remain at around 9.5%, by simple arithmetic, it will contribute 4.75 percentage points to retail inflation. This means the contribution of other components of retail inflation must be restricted to 1.25 percentage points if retail inflation has to be contained at 6%. This is impossible to achieve unless food inflation is curbed. Since monetary policy has very little to do with food inflation, the onus is on the government to strengthen RBI’s hands in its fight against inflation.
Rajan will continue his fight against inflation till he wins. This doesn’t necessarily mean that RBI will wait till January 2016 for a rate cut. If the inflation expectations are curbed and its trajectory points to achieving the target, we can see a rate cut well ahead—sometime next year. Inflation is like a cancer: at the early stage, it can be tackled through radiation; if there is a delay, then chemotherapy is mandatory; and if there is further delay, there is no choice but operation and prolonged treatment. By not being aggressive in its fight against inflation at the early stage for fear of hurting growth, RBI had allowed inflation to get entrenched. Rajan will not cut the policy rate till his mission is accomplished.
Theoretically, a cut in SLR ensures that commercial banks have more resources to support credit demand—as and when that picks up in Asia’s third largest economy. According to the latest data, growth in bank credit for the 12 months ended 22 August fell to less than 11%—a level last seen in December 2009 when the economy was faltering in the aftermath of the collapse of US investment bank Lehman Brothers Holding Inc.—but with growth gaining momentum, banks will see credit flow gathering momentum.
There is another reason why RBI can go for a cut in SLR. In accordance with the Basel III framework on liquidity standards, Indian banks will have to maintain the so-called minimum liquidity coverage ratio (LCR) in a phased manner, starting at 60% from January 2015, and attaining 100% by January 2019. LCR refers to highly liquid assets, mostly in the form of government bonds, held by banks. It is designed to ensure that banks can meet all short-term obligations and avoid any liquidity disruptions. Since bonds held to meet LCR will be outside the SLR obligation, it is logical that RBI brings down the floor for government bond holding in phases, as otherwise after LCR and SLR, the banks will be left with little money to meet the loan demand of the private sector. Even though there is a slump in credit demand, RBI can continue to cut banks’ mandatory government bond holding as this will also be a message to the government to keep its market borrowing in check by reining in the fiscal deficit.
In its June policy document, RBI had said that “if the economy stays on this course, further policy tightening will not be warranted” and “if disinflation…is faster than currently anticipated, it will provide headroom for an easing of the policy stance”. Later, in August, it said the upside risks to the target of containing retail inflation within 8% by January 2015 remained and, therefore, it was “appropriate to continue maintaining a vigilant monetary policy stance”. It is too early to give up the vigilance.
Inclusion and money-laundering
Banks are on overdrive to make India’s most ambitious financial inclusion plan a resounding success. Going by government estimates, already 40 million accounts have been opened. While banks’ enthusiasm for opening accounts is understandable—Prime Minister Narendra Modi is personally monitoring the progress of the scheme—the industry needs to be careful about three likely offshoots of such a programme: multiple accounts, money mules and smurfing. While many people who were never embraced by banks will be tempted to open multiple accounts to get insurance cover and overdraft (banks are not equipped to detect such cases), they may end up also helping money-laundering. A money mule or a “smurfer” is a person who transfers the ill-gotten money of others; smurfing—also known as structuring—is a method of placement through smaller deposits of money to defeat suspicion of money-laundering.
