Springing a mini surprise, RBI again increased the cash reserve ratio (CRR) for banks by another 25 basis points, taking it to 8.25%, effective May 24. This followed the equally unexpected 50 basis points hike a fortnight earlier. In its policy, RBI elected to keep its policy interest rates (namely, the bank rate and Laf repo and reverse repo rates) on hold.
The objective was not just to control inflation, but more importantly to kill inflationary expectations, deemed a bigger threat than inflation itself. Also hammered incessantly in the section on RBI?s policy stance is its intention of ?active demand management of liquidity?using all policy instruments at its disposal flexibly, as and when the situation warrants?. The target growth of the broad money supply measure (M3) has been set at 17% for 2008-09, even lower than that for 2007-08, to facilitate a reduction in WPI inflation to 5.5% by end-March 2009. This stance should?ve been expected, given the increasingly monetarist view that RBI has adopted since late 2006 in its approach to inflation.
Post facto, the reaction of markets is more of a surprise. Equities rose sharply after the announcement, and the bond market, which was expecting a repo hike, pulled yields on benchmark 10-year government bonds down by 12-15 basis points. There was evident relief on being spared a rate hike. The CRR hike was ?only? liquidity management. This, as analysts spoke of a balance between inflation control and continued growth.
This reading is probably incorrect. Interest rates are likely to increase more uniformly than would be the case with a repo hike. Examine how the liquidity adjustment facility (Laf) works, and its link to banking sector funds and thereby to M3 (an inadequate measure of liquidity, but that?s another story). The three main contributors to M3 growth are bank loans, foreign fund inflows and government borrowings. The RBI has little control on the latter and excess foreign capital inflows (over and above current account outflows) are likely to remain muted in the near future. So the pressure point for RBI is bank credit growth.
Banks fund credit growth mainly through deposits. But will the reduced deposit base mean merely reduced lending or are interest rates on loans likely to go up as well? For one thing, higher reserve deposits with RBI means higher costs of funds for banks, since no interest is paid on CRR balances. Second, banks have to compete harder for the smaller effective base of deposit funds and resort more heavily to non-deposit borrowings to fund credit growth. Consider the effect of these on interest rates.
After the surge in banking sector liquidity in mid-April (as measured by Laf deposits with RBI), liquidity again seems to have dried out by end-April. Now, RBI?s CRR hikes on May 10 and 24 will take away another Rs 15,000 crore. Liquidity then will remain barely surplus in the next couple of months. The Centre has a large market borrowing programme in H1FY09. All this will push up interest rates across the entire maturity spectrum of the yield curve.
Compare this to a repo rate increase, whereby banks will have to pay more for overnight borrowing from RBI?s Laf window (and consequently for all overnight interbank borrowings). This impact is confined to the shortest maturity of the yield curve (with market perceptions determining rates at longer maturities). The yield curve might shift parallelly upwards from the higher repo anchor point, or the curve might flatten. The benchmark rate for most pricing decisions in bond markets is the 10-year g-sec, and its response to a repo hike is hard to tell. A liquidity shortage, in contrast, will raise the yield curve in a more uniform manner across all maturities. Recall the earlier experience over most of 2006, when RBI had increased repo rates from 6% to 7.25% with barely a flutter from banks? prime lending rates (PLRs). It was end-2006?s CRR hikes that pushed up PLRs.
Will the latest tightening measures control inflation? Given RBI?s premise of the link between inflation and M3 growth, this will depend on a slowdown in M3 growth, arising from slower bank credit growth. This in turn will depend on the cost of credit. The logical inference is that credit growth will slow only if the cost of credit increases and demand for bank credit drops; you cannot have lower credit demand if the cost of credit remains the same. If miraculously interest rates do not increase, credit demand will remain high. Banks, on their part, will have access to limited funds to meet this credit demand, and loan rates will increase as banks try to maintain their margins in an adverse cost-of-funds environment. In other words, something does not square up, whichever way one slices the policy channels, about the link between interest rates, bank credit and M3 growth.
Expect rates to rise, bank credit growth to slow, M3 growth to fall, and with it, inflation. And yes, growth will be adversely affected.
The author is vice-president, business & economic research, Axis Bank. These are his personal views