The markets are enthused by the Reserve Bank of India's (RBI's) cut in the cash reserve ratio (CRR), with equity, bonds and currency rallying. While the Sensex was up and the rupee strengthened to 50 against the US dollar, bond yields were down by 4bps (100 basis points make 1 percent) post the CRR cut.
The government has played spoilsport to a repo cut in this policy, which, if it had come through, would have led to a stronger rally in the markets.
The market rally has more steam left given expectations of rate cuts down the line but the fact that the RBI is now becoming more tied to the government is worrying. It is a factor to watch out for in the coming months.
Liquidity conditions forced the RBI to cut CRR by 50 bps in its third quarter monetary policy review on Tuesday, 24 January. Liquidity, as measured by bids for repo in the LAF (liquidity adjustment facility) of the RBI averaged over Rs 150,000 crore on a daily basis last week. The demand for funds from the RBI had gone up by Rs 70,000 crore over the last four months, despite the RBI infusing Rs 61,000 crore of primary liquidity into the system through OMO (open market operations) bond purchase auctions.
The government has been drawing on its overdraft limits from the RBI and was overdrawn by around Rs 15,000 crore as on 13 January 2012. The RBI’s bond purchases and government spending have failed to bring down the liquidity deficit. The liquidity deficit of 150,000 crore is higher by Rs 80,000 crore over the RBI’s comfort zone of around Rs 60,000-70,000 crore. Hence the CRR cut.
The RBI has been maintaining that CRR is a monetary tool and indicates its monetary stance. In fact, the central bank has indicated that the CRR cut could be a precursor to cuts in repo rates down the line. It has cited sticky non-food manufacturing inflation, which at over 7 percent levels, is higher than the long-term average of 4 percent, for not cutting repo rates. However, the underlying reason for the RBI holding on to repo rates is the government’s utter mismanagement of its finances.
The government is borrowing Rs 93,000 crore more than planned in fiscal 2011-12. The fiscal deficit is expected to go up by 1 percent from budgeted levels of 4.6 percent due to higher subsidy payouts. Subsidy payouts have led to the revenue deficit touching 91.3 percent of the budgeted target in the April-December 2011 period. The fact that the government is unable to control its revenue deficit reduces spending on productive investments. Lower capital account spending leads to supply deficiencies, leading to higher prices.
The RBI has been forced to step in to contain the impact of the higher government borrowing on both liquidity and bond yields. It cited tight liquidity conditions to undertake a series of bond purchase auctions, which in effect is turning out to be backdoor deficit financing.
The case for a repo cut is strong. GDP growth is revised downwards from 7.6 percent to 7 percent for fiscal 2011-12. Planned corporate investments have declined by 77 percent in the second quarter of 2011-12 on a year-on-year basis. Credit growth, at below 16 percent, is well within the RBI’s target of 17 percent for 2011-12. Global economic conditions are expected to weaken with problems in the eurozone.
Inflation is expected to trend down to below 7 percent in March 2012 as per the RBI’s expectations even though there is some upside risk in the form of higher power tariffs (due to increase in input costs such as coal prices) and the pass-through of rupee depreciation into the economy. The rupee is still down over 10 percent against the US dollar over the last four months despite a rally of close to 5 percent in the month to date.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.