RBI adopted a cautious tone in easing policy for its mid-year review, choosing to cut the CRR by 25 basis points, and keeping the repo rate on hold. The focus remained predominantly on inflation, but the tone has become more supportive of growth, with the stated declaration of a likelihood of further easing in the fourth quarter of FY13.
So what does the CRR cut do to the bottom line of banks, in terms of enabling them to pass on the lower rates to borrowers? The argument is that more (assured) liquidity with banks will induce a swifter transmission of policy easing, rather than a reduction in repo rates. This is questionable at best, which can be demonstrated with some back-of-the-envelope calculations.
The 25 basis point CRR cut will release R17,500 crore which, deployed for credit, will earn banks, say, 11%, i.e. R1,800 crore. This is a mere 4 basis points (0.04%) increase in incomes for banks, which is the extent that logically base rates can be cut, if interest margins are to be protected. Much of this will also be neutralised by the increased provisioning requirement on standard restructured assets.
Compared to this, a reduction in repo rates, if accompanied by sufficient liquidity, can serve to bring the short end of the yield curve down. As the accompanying graph shows, all the short-term rates that determine the bulk of costs of funds for banks tend to converge, with even a liquidity deficit, if the deficit falls to less than 1% of NDTL, particularly under expectations of falling interest rates. Of the R65 lakh crore of deposits, using data from a sample of banks, just under less than half will re-price at lower interest rates in less than a year, and a fifth in less than 3 months. That?s about R12 lakh crore. Re-pricing at 2 percentage points lower than the rates, they would have been booked before would amount to a saving of R25,000 crore in funds? cost to banks. That?s 40 basis points (0.4%), which might enable a 40 basis point base rate cut.
The crux, of course, is the provision of ample liquidity in the system, so that short-term rates do not diverge from policy rates. Already, system liquidity has tightened to near R1 lakh crore. In the near term, with the ongoing festival season, cash withdrawals can be expected to add to the deficit. Over the course of the second half of FY13, the liquidity gap can be expected to widen even further. All of this ensures the need for liquidity support from RBI.
What is the best combination of instruments to achieve balanced liquidity? The swiftest, surest and most broad-based instrument is the CRR. However, the CRR is already down to 4.25%, lower than at any time in near history. Global (and domestic) economic risks warrant some caution in keeping a liquidity buffer, since renewed global volatility might require large liquidity infusions (Europe?s concerns are gradually welling up again; even a negotiated fiscal arrangement in the US might spark a significant slowdown, and homegrown fears of a ratings downgrade). The fact that CRR had been hiked to 9% prior to the financial crisis enabled a rapid infusion of liquidity in the aftermath.
On the other hand, banks? holdings of SLR securities are currently almost 30% of deposits (against the mandated holdings of 23%). These excess holdings can be used as collateral for LAF borrowings and Open Market Operations of RBI. The latter, in addition, entail a higher cost of funds for banks, compared to the costless infusion via a CRR cut.
The other interesting question is the scope for further monetary policy easing going forward. The key is the inflation trajectory. A combination of base effects and lagged second and third order effects of the fuel price increases will keep inflation rates high till February, probably at levels close to 8%, before dipping in March (again due to a base effect) and then persisting at 6.8% levels for much of FY14. This automatically limits the headroom for further easing, even with a forward view on moderation of inflationary pressures. The underlying factors that might determine the inflation trajectory will be the subject of a future column.
The author is senior vice-president, business & economic research, Axis Bank. Views are personal