Lapping up liquidity

Indian Express, 4 January 2010

The consensus on food price rise in the government appears to be moving towards the view that this is not a problem that interest rate hikes can solve. At the same time there are expectations in financial markets that the RBI will tighten monetary policy. What should the RBI do, if it needs to be seen doing something, but does not want to hurt growth? Its best option is to announce an increase in the cash reserve ratio by 1 percentage point in two to three steps to take place over the next couple of months.

The low demand for credit over the last few months has resulted in excess liquidity with banks. Banks have been parking an average of Rs 1 lakh crore a day with the RBI under the reverse repo facility. Over the last few days this has come down a little and banks have been depositing about Rs 75,000 crore with the RBI. For the latest data available for November the growth in credit was not encouraging as non-food credit was still growing at only about 10 percent per month for seasonally adjusted bank credit data. The figure suggests that banks may continue to have excess liquidity for some time to come. The RBI has also been expressing concern that banks are lending money to mutual funds, a sector not regulated by the RBI. This makes RBI uncomforatable especially after the October 2008 experience, when this sector saw a sudden withdrawl of funds.

If the RBI were to raise interest rates, which would have to be through raising the reverse repo rate, i.e. the rate at which RBI borrows money from banks, it would make it more attractive for banks for park money with RBI instead of with, say, mutual funds. They would, however, continue to have excess liquidity. The repo rate, the rate at which RBI lends to banks is currently irrelevant as there have been no repo transactions for months. When banks have more than adequate money, they do not borrow from the RBI.

Finally, RBI has the option of raising the cash reserve ratio (CRR). This is the best option because in the present circumstances as the rise in the CRR pulls out the excess Rs 75,000 crores. Instead of parking the money voluntarily with the RBI, banks will do it because they are required to do so. For those outside the banking system this will not be of any consequence. It may, at the margin, affect bank profitability, but would do no great damage. However, one risk this poses is that if there is a CRR hike now then banks may be even more averse to lending than they presently are, expecting that there may be another CRR hike around the corner. This would be because if the RBI only announces one hike it would not be able to announce a very large one since there is no sudden change in circumstances to warrant it. A single hike, in the present circumstances, could be a maximum of 50 basis points. Since this would not get the job of pulling the excess liquidity out of the system done, it would mean that banks would expect another CRR hike some time soon. Uncertainty about monetary policy would likely make banks hang on to liquidity rather than give out more credit. Such a situation would be harmful to the present, rather shaky, growth in non-food credit currently underway. To avoid such a situation, the RBI should announce a calender for CRR hikes that aim to pull out about Rs 50,000 crore out of banks over the next couple of months. The certaintly created by the RBI's calender of CRR hikes will reduce the present uncertainty in the market.

With a hike in CRR the RBI would also be able to continue on the path of signalling that it is going to start withdrawing the excessive easing of monetary policy that was done following the 2008 crisis. This path, which would likely not prompt banks to start raising rates as a response, is likely to cause least damage. Also, until the US Fed starts raising interest rates, which Ben Bernanke, Chairman of the Federal Reserve Bank has indicated he may not do for the next six months, it would increase interest differentials.

While the present level of the rupee is much below what it was when the 2008 crisis hit, it is possible, perhaps, for the rupee to go to at least Rs 42 to the dollar before we start seeing pressure from exporters. This is something to be kept in mind before the RBI seriously tries to obtain a higher level of interest rates in the economy. A higher interest differential will attract capital despite all the hundreds of levers and capital controls that the RBI may have. Were the RBI to come under pressure to prevent appreciation by intervening in foreign exchange markets, it would increase liquidity in the system. This would put the RBI in a difficult spot given that there is already excess liquidity in the system today. If the RBI were to then try to sterilise its intervention by selling MSS bonds, even if the present MSS ceilings allow it to do so, it will only makes its life more difficult, given the already large stock of government bonds it has to sell already to meet the government's borrowing requirement, and the pressure that is putting on long run interest rates.

In summary, the best way out for RBI now may be to hike the CRR. This will have little effect on those outside the banking system and is unlikely to prompt banks to raise interest rates. In the present circumstances, if the CRR hike is about 1 to 1.25 percentage points it will not reduce the availability of credit (assuming credit demand continues to grow at present rates.) In this, of course, the RBI must make sure that it shapes market expectations such that banks increase, rather than reduce, lending over the coming months.

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