RBI has developed a knack in bowling googlies at market analysts, using gotcha manoeuvres to confound. And, ex post, these measures are the sort that make you go I should have thought of that and seen that coming.
The usual policy measures were left unchanged; LAF repo rate and the cash reserve ratio (CRR) were not cut. And the Macroeconomic and Monetary Policy Review released just before the policy left little doubt on the reasoning why: The Reserve Bank cut CRR by 125 basis points (bps) and front-loaded the policy rate reduction by cutting the repo rate by 50 bps in April 2012. It, however, paused at its mid-quarter review in June 2012 factoring in inflation persistence and macro-economic risks that emanated from lack of momentum in fiscal consolidation. Significantly, while there is slack in the economy, inflation remains persistent. Going forward, monetary policy space needs to be created through fiscal adjustment and structural measures to improve supply conditions and boost the investment climate, so that the revival is supported in a non-inflationary manner. Cant be more clear than that.
Was the policy stance defensible Should RBI have done more Disclaimer: I am of the persuasion that monetary easing was definitely an action needed, if not immediately in reducing cost of funds for loans, at least as a booster of sentiment to try and reverse the cycle of macroeconomic imbalances which has bedevilled us. There is, of course, a clear and present risk that such action, in the absence of complementary measures, might just serve to stoke consumption (and hence inflation), but on balance, this might be a risk worth taking. But thats a separate story.
The focus here is on the 1 percentage point cut in the statutory liquidity ratio (SLR) from 24% of deposits to 23%. Make no mistake, SLR has become as much of the monetary policy repertoire as the repo rate and CRR, this is clearly an easing action, although probably not as potent as a CRR cut or even a repo rate cut. And this ties in with the earlier comment that a 50-basis-point repo rate cut (say), at this point, might have been ineffective in inducing banks to lower their lending rates.
But why should this have been cut now As a reference, the SLR had been cut from 25% of deposits in December 2010 and then 2% of NDTL (net demand and time liabilities) made incrementally available to banks (as the marginal standing facility, MSF, at repo rate plus one) over 2011 and 2012. Banks SLR holdings, in the aggregate, are close to 29%, so the SLR is presumably not a binding constraint.
The first point is that the trend reduction in the SLR is welcome as a structural financial market reform step, since the SLR is one of the last remaining financial repression legacy structures (this is technical jargon, not be interpreted as cruelty to banks or anything), resulting in at least some distortion in financial market price signals (although the recent revelations regarding conduct of financial markets might lead to some vehement repudiation of this statement). In addition, this statutory sequestering also has implications for the benchmark yield curve, since an offsetting risk mitigation measure provided by RBI is leeway for banks to ringfence the mark to market risk of their government securities (G-secs) portfolio, via a hold to maturity portion. This is one of the features identifying as hindering the emergence of a benchmark yield curve, which, inter alia, is critical to develop a corporate bond market.
Second, reducing the SLRand consequently the need to hold G-secsis probably a gentle nudge to reduce the magnitude of market borrowings by the government, since the demand of G-secs (versus the supply) is likely to drop, thereby raising yields on these papers and raising the cost of borrowings. This is clearly an incentive to move on fiscal consolidation which RBI has indicated as a precondition to deeper monetary policy easing.
Third, and the most relevant in the immediate horizon, is incentivising banks to cut lending rates. A developing conundrum is that despite a drop in LAF (but not CBLO, which is yet another story) borrowings, certificate of deposit (CD) rates (a measure of cost of funds for banks) have not fallen commensurately. A probable reason is that there is still a lot of uncertainty regarding future liquidity deficits, and the availability of collateral to be able to tap the LAF window. In the future, in particular, uncertainty from potential volatility in the eurozone, foreign currency funds outflows, the effect on the rupee, a need to intervene in forex market might result in a consequent draining of domestic funds. Banks need some certainty on the availability of long term-funds from RBI. It was precisely the need to mitigate such concerns that the ECB has been conducting long-term repo operations (LTRO). Due to various structural factors, this will not be feasible in India in the near future. The SLR cut is an alternative and will probably provide comfort on long-term funds availability to at least those banks which are close to their SLR levels.
Monetary easing alone, to repeat an obvious, cant resolve all the problems. It has to be a concerted effort both from the central and state governments and RBI, via monetary, fiscal, tax, industrial, export, land and labour policies. However indirectly and mildly, RBI has again contributed its bit in getting Indias economy out of the critical point at which economic activity can spin up or down depending on how policy uncertainty is addressed.
The author is senior vice-president, business & economic research, Axis Bank. These are his personal views