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Exclusive: Will the RBI slash interest rates on Monday?

Upasna Bhardwaj/Mumbai 14 Sep 12 | 10:26 AM

Now that the government has hiked diesel prices, which in turn could stoke inflation, will the Reserve Bank of India (RBI) continue to remain hawkish, or can one expect a rate cut in the upcoming Monetary Policy review?

As we come closer to the policy, questions on possible monetary action either through a cut in Cash Reserve Ratio (CRR) and/or Repo rate become even more pronounced. There has also been a rising debate over whether CRR should be abolished altogether.

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While, banks would always prefer to remove the reserve requirements as they do not earn any interest on those funds, the central bank would like to keep buffer for the depositors' security. Now with deposit rates being slashed across banks over the past few days, CRR cut speculation has increased significantly.

However, one needs to question as to what would a cut in the reserve ratio achieve? A cut could help in either easing the tight liquidity conditions or facilitate bank advances to productive sectors to stimulate growth.

At this juncture none of the two objectives could be achieved. Liquidity conditions have turned substantially benign with average liquidity deficit in the system having declined to Rs 40,000 crore since July compared to Rs 97,000 crore between April – June. In fact, even for the next two months, we expect liquidity deficit to average Rs 60,000-80,000 crore, well around RBI’s comfort zone.

Meanwhile, the slowing economy is taking a toll on the credit off-take across sectors. Moderating loan demand has brought the credit/deposit ratio down to 75% from a record high 78.1% towards March-end. Due to lower demand, banks are left with surplus funds thereby reducing the deposit rates to protect margins.

Also, as weakness in economic activity persists and banks remain burdened with burgeoning non-performing assets, asset quality becomes an even bigger reason to worry about. This may keep banks cautious while providing for loans.

Moving into December, we may begin to witness greater stress on liquidity conditions, which in turn may warrant a CRR cut. Before that, any intermittent spike in liquidity deficit led by seasonal demand is likely to be met by Open Market Operations (OMOs). We expect RBI to resume OMOs towards the end of October as seasonal increase in currency in circulation may be a drain on liquidity.

Nonetheless, with the overall funding costs declining, we may witness a gradual cut in base rates across banks, even as the RBI continues to hold the Repo rate unchanged.

We expect the RBI to hold both the repo and CRR unchanged in the ensuing meeting and reassess its decision in the October policy once some concrete steps are undertaken by the Government to erase the fiscal excesses and as the inflation trajectory becomes clearer.

While RBI’s focus on policy action and inflation is completely justified, we believe that a sharp slowdown of economic activity will prompt the Central Bank to ease the Repo rate by 50 basis points in the second half of 2012-13.

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The author is an economist at ING Vysya Bank

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