Sujan Hajra: Rate cut should be accompanied by liquidity enhancing measures
Until the tight banking sector liquidity condition is mitigated, the impact of any policy rate cut by the RBI would largely be symbolic
There is a view that monetary policy action is most effective when it surprises the market participants. The Reserve Bank of India (RBI), it seems, is practicing the same. Some of the RBI’s recent policy actions not only surprised the market, but were also not synchronous with recommendations of the Technical Advisory Committee on Monetary Policy set up by the RBI.
In this milieu, rather than trying to hazard a guess on RBI’s likely action in the forthcoming mid-quarter review on 18 June 2012, this is what we think the RBI should do at the current juncture.
Despite RBI’s continued discomfort on the inflation front, the sharp growth slowdown has now become a bigger concern. Consequently, reversing the aggressive monetary tightening practiced over the last two years; the RBI is on the easing path. The CRR (cash reserve ratio) has been cut by 125 bps in two tranches – Jan’12 and Mar’12 – and repo rate by 50 bps in Apr’12. While the continuance of the easy monetary policy stance remains unquestioned, the extent of easing, timing and the choice of instruments remain matter of conjecture.
Over the last 24-months, banks have been net borrowers from the RBI through the LAF (liquidity adjustment facility) window. In 1QFY13 so far, banks, on an average, are borrowing nearly Rs 100,000 crore (US$18 billion) everyday from the RBI under the LAF. Net borrowing by banks under the LAF means banks’ assets (mainly loans and investments) are expanding faster than liabilities (mainly deposits and market borrowings) and the shortfall is being met by LAF borrowing.
A rate cut in a tight liquidity situation reduces banks’ funding cost as the cost of borrowing from the RBI reduces. However, since bank credit/investment demand is higher than accretion through bank deposit/borrowing, banks do not feel the need to cut deposit/lending rates. For the same reason, most banks did not transmit the effect of the 50bps cut in repo rate in Apr’12. In our view, another repo rate cut at this juncture, on its own, would also be largely symbolic with little reduction in bank deposit/lending rates.
In contrast, if liquidity under the LAF turns into a surplus, it would mean that banks’ assets are expanding slower than liabilities. A rate cut in that situation would reduce banks’ earnings by reducing interest income on funds parked under the LAF. With supply of funds (liability) being higher than demand for funds (assets), banks are likely to reduce both the deposit and lending rates.
We, therefore, feel that to make monetary easing effective, any further rate cut by the RBI should be preceded or at least accompanied by liquidity enhancing measures. The RBI can enhance liquidity through cuts in CRR or purchase of government securities under the OMO (open market operation). A CRR cut instantly increases banking sector liquidity for which there is a major need currently.
Even without any change in the policy rates, the LAF liquidity turning from a deficit to a surplus has an effect of 100bps rate cut. In a tight liquidity situation banks borrow from the RBI at repo rate making it the benchmark policy rate.
In liquidity surplus situation, reverse-repo rate becomes the benchmark policy rate as banks park excess funds with the RBI at this rate. With 100bps difference between repo and reserve-repo, transition from tight to surplus liquidity, therefore, reduces the benchmark policy rate by 100bps.
Against this backdrop, we feel that apart from continuing with OMO, the RBI should reduce the CRR by at least 50bps on June 18. The sagging morale of the financial market would get a boost if the same is accompanied by even a token 25bps rate cut. For the current financial year as whole, we estimate the RBI to infuse liquidity worth Rs.300,000 crore (US$55 billion), one-third of it through 150 bps CRR cut and the rest through OMO. Meanwhile, we are keeping our fingers crossed and antacid bottles handy for the continuance of the bumpy ride.
Sujan Hajra is the Chief Economist of the Anand Rathi Group. He was earlier with the RBI for 16 years; lastly as Director, Department of Economic Analysis & Policy. Views expressed are his own and do not necessarily reflect those of his employer.
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