Why the RBI must cut interest rates

The sharp fall in GDP growth in 2011-12 has been accompanied by a sharp fall in monetary aggregates that affect the overall liquidity in the system.

GDP growth for the year ending March 2012 has cooled to 6.9 percent from 8.4 percent the previous year.

Similarly, monetary aggregates of deposit, credit and broad money supply (M3) growth for fiscal 2011-12 have also come off by 2.2, 5.3 and 2.9 percentage points, respectively, from their growth rates in 2010-11. The table below gives the growth rates of monetary aggregates over a ten-year period.

[caption id=“attachment_258297” align=“alignleft” width=“457” caption=“Source: RBI * As of 9 March, 2012”]  [/caption]

The correlation of GDP growth to growth in monetary aggregates is high as seen in the 2005-06 to 2008-09 period, when GDP growth of over 9 percent was accompanied by healthy growth rates in monetary aggregates with deposit, credit and M3 growing by 21 percent, 27 percent and 20 percent respectively. GDP growth in the subsequent period has fallen to below 9 percent levels, and has growth in monetary aggregates as seen from the table.

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The current financial year has seen the slowest growth in bank deposit and M3 since financial year 2004-05.

The sharp fall in aggregate monetary growth in 2011-12 has shown up in liquidity tightness in the financial system. Liquidity, as measured by bids for repo in the LAF (Liquidity Adjustment Facility) of the RBI, has consistently been in negative territory throughout the current financial year.

The liquidity deficit peaked on 26 March, when banks borrowed a record Rs 1,95,000 crore from the RBI.

[caption id=“attachment_258301” align=“alignleft” width=“380” caption=“Liquidity has remained tight despite the RBI infusing Rs 2,20,000 crore into the system through the purchase of government bonds. Reuters”]  [/caption]

Liquidity has remained tight despite the RBI infusing Rs 2,20,000 crore into the system through the purchase of government bonds (Rs 1,40,000 crore) and lowering the CRR (cash reserve ratio) rate from 6 percent to 4.75 percent, which released Rs 80,000 crore into the system.

Two factors that have negated the RBI’s liquidity infusion are its sales of dollars worth about Rs 1,00,000 crore and the fact that notes in circulation have soared by Rs 1,15,000 crore.

The RBI, in effect, has only put in to the system the liquidity that has been sucked out.

The bigger picture of the structural liquidity deficit caused by a fall in monetary aggregates has not been addressed.

It is critical that the RBI addresses the structural liquidity changes in the next financial year if the government is to achieve a GDP growth of 7.6 percent. The fact that the government is planning to borrow a net Rs 4,79,000 crore from the market to fund its fiscal deficit of 5.1 percent of GDP has a big impact on banking system liquidity.

Banks tend to increase exposure to government bonds when liquidity is tight as bonds are used as collateral to borrow from the RBI. Banks bought government bonds equivalent to 38 percent of their incremental deposits in fiscal 2011-12, well above the statutory limit of 24 percent. If liquidity continues to remain tight in fiscal 2012-13, banks will continue to increase their exposure to government bonds, which will result in lower credit growth.

What can the RBI do?

On the monetary side, the RBI can infuse liquidity into the system by reducing CRR, buying government bonds and lowering SLR (statutory liquidity ratio). The CRR at present is 4.75 percent, and the RBI’s medium-term objective for CRR is 3 percent.

The RBI may not want to reduce CRR to 3 percent given issues of inflation, but it will cut CRR by 75 basis points to 4 percent in 2012-12. The CRR cut will add around Rs 50,000 crores of liquidity into the system.

The central bank has been resorting to back-door deficit financing for the last four years by buying government bonds. The central bank may not want to consistently finance the government’s deficit, as it is inflationary in nature. However if liquidity demands that the RBI buy government bonds, it will do so.

The large borrowing programme of the government makes an SLR cut difficult to implement, as banks are the single largest buyer of government bonds. SLR cut will reduce pressure on banks to buy government bonds, leading to more liquidity available for credit.

The RBI has the option of buying US dollars to infuse liquidity into the system. But the conditions for buying the greenback are not conducive as the Indian Rupee is trading 15 percent below its highs seen in 2011. The central bank will buy dollars only when there are sustained portfolio flows into the country leading to the rupee-strengthening sharply.

Rate cuts are necessary

The repo rate is a tool that the RBI can use to improve liquidity in the system. Lower interest rates do not directly add liquidity into the system, but can indirectly help liquidity.

Banks, by passing on lower interest rates to borrowers, can increase demand for credit leading to a multiplier effect. The multiplier effect helps raise deposit as well as broad money growth. However, lower rates work with a lag and the longer the RBI waits to cut the repo rate, the longer it will take for liquidity conditions to ease.

The RBI should do an analysis of why monetary aggregates are down despite liquidity infusion measures and present it to the public in its annual policy statement in April 2012.

A clearer picture of liquidity will help markets navigate through large government borrowing as well as help the system to price credit efficiently. The market has been living in uncertain liquidity conditions for almost two years and tight liquidity conditions for a third year running will depress market sentiment sharply.

A depressed market sentiment leads to rising bond yields, which are not conducive for achieving higher growth rates.

Arjun Parthasarathy is the editor of www.investorsareidiots.com a web site for investors.