It’s fairly certain that the Reserve Bank of India (RBI) will pare its growth forecast for the Indian economy when it announces its quarterly review of monetary policy on Tuesday.
The annual monetary policy in May had projected 8% growth for India’s gross domestic product (GDP) in fiscal 2012; it was cut to 7.6% in October. This time around, the central bank will probably revise it downwards to 7%.
In the first half of the fiscal year, the economy grew at 7.3%, but it has been losing steam—the growth in the second quarter was sharply down to 6.9% from 7.7% in the first quarter.
Most analysts agree the growth projection will be pared (no one will be surprised even if RBI pegs it at 7% “with a downward bias”) and there will not be any rate cut, but the market is divided on whether RBI should go for a cut in banks’ cash reserve ratio (CRR), or statutory liquidity ratio (SLR), to ease pressure on liquidity. CRR is the portion of deposits banks need to keep with RBI, and under SLR norms, banks must invest at least 24% of their deposits in government bonds.
The noise for a CRR cut is getting louder, with banks borrowing on average about Rs 1.26 trillion every day from RBI’s repo window this month. Banks pay 8.5% for this short-time money to take care of their temporary asset-liability mismatches. There have been stray cases of some banks paying 9.5% to borrow from RBI under the so-called marginal standing facility (MSF).
Banks need to offer government bonds as collateral to borrow from the repo window. Since SLR is 24%, they must have higher investment in government bonds to be able to borrow from the repo window, and those who don’t have that can bring down their SLR portfolio to 23% and borrow under MSF at a higher rate.
Even though the average SLR holding of the banking industry is around 29% (against the regulatory norm of 24%), not all banks have excess government bonds in their portfolio, and hence they need to pay more to borrow from RBI. A cut in SLR will help them. At the same time, it will also bring down the overnight call money rate, which has recently gone up to 9% and above. Theoretically, the rate of overnight call money—where one bank borrows from another—should veer between 8.5% (repo rate) and 7.5% (reverse repo rate). RBI infuses liquidity into the system at 8.5% and sucks out excess liquidity at 7.5%.
Since March 2010, RBI has raised its key policy rate 13 times and kept the financial system in a cash-deficit mode to make the repo rate effective. Its stated plan has been to keep the cash deficit at around 1% of the banking industry’s deposit base—roughly Rs 60,000 crore. But the daily deficit has been more than double of this amount in January.
One of the reasons behind this is RBI’s dollar sale. In the three months till November, RBI had sold about $6.3 billion worth of dollars, and if one takes into account its dollar sale in December (data for which is not available as yet), the total sale could be at least $8 billion. For every dollar RBI sells, an equivalent amount of rupee leaves the system. RBI sold dollars to rein in runaway depreciation of the local currency. With foreign investors buying Indian equities in January, the trend has reversed and the rupee has appreciated about 6% against the dollar after losing 16% last year.
Even if RBI does not sell dollars any more, the liquidity shortage will continue, and to tackle this and ensure that the government’s annual borrowing programme is not affected, RBI has been infusing liquidity by buying bonds from banks under its so-called open market operations (OMOs).
The government has raised its borrowing plan for the year twice to bridge the fiscal deficit, at a record Rs 5.14 trillion. Net of redemption of old bonds, the government is raising Rs 4.36 trillion from the market.
So far, RBI has infused Rs 71,878 crore through OMOs, about 16.5% of the government’s net borrowing. Bulk of the money has already been raised and the government needs to borrow an additional Rs 74,000 crore in the rest of the fiscal year.
This means RBI will continue OMOs. Apart from infusing liquidity, RBI’s bond buying—through auctions—also helps “manage” the yield on bonds. The yield on the 10-year benchmark bond is currently around 8.2%, sharply down from 8.97% in November. Theoretically, this means the government is borrowing 10-year money at a cheaper rate than what banks are paying RBI to borrow one-day money (8.5%).
The cash deficit in the system will continue till the end of the fiscal year. It will, in fact, intensify in mid-March when Indian firms will pay advance tax for the quarter, but this can get neutralized as typically the government spends quite a bit in the last few weeks of any fiscal year, releasing money into the system.
I will not be surprised if RBI cuts CRR by 50 basis points (bps) to bring down the systemic cash deficit to some extent. One basis point is one-hundredth of a percentage point. A 50 bps cut will infuse about Rs 30,000 crore. This will be a liquidity enhancement measure and will not signal the beginning of a loose monetary policy, as the daily cash deficit will continue to remain around Rs 1 trillion, still higher than 1% of the banking industry’s overall deposit base.
RBI will not be in a hurry to announce the beginning of the reversal of its policy stance as non-food, manufacturing inflation, the proxy for core inflation, continues to be high. Wholesale price inflation dropped to a two-year low of 7.47% in December, but that was solely led by a drop in food inflation, and core inflation remained at 7.7%. This is lower than November’s 7.9% and the lowest in the last five months, but a level with which RBI will not be comfortable.
In the December policy review, RBI had said that “while inflation remains on its projected trajectory, downside risks to growth have clearly increased” and, “from this point on, monetary policy actions are likely to reverse the cycle, responding to the risks to growth”. India’s factory output jumped 5.9% in November after contracting 4.7% in October, but the volatility makes it difficult to plot any trend in industrial growth. The time for reversal in cycle is not ripe as yet but this policy review could tinker with CRR purely as a liquidity management tool.