RBI applies demonetisation band-aid as it searches for remedies

Shishir AsthanaMoneycontrol Research

Banks are moving from one shock to another ever since demonetization was announced on November 8. They had to help distribute cash to their customers, collect excess cash from those hoarding it and then help replace old notes.

It seemed that they had been rewarded for their efforts as almost all banks were flooded with low-cost deposits. But though banks saw their cost of funds come down sharply, the velocity and amount of funds were so high that they were not able to enjoy the benefits of better spreads by lending fast enough.

Banks ended up buying government bonds pushing yields lower. The benchmark bond yield fell to 6.11 percent, its lowest in seven-and-a-half years and below the policy rate, suggesting an excess liquidity situation and reinforcing market perceptions of a rate cut. The RBI was running out of bonds to give to the banks who were willing to buy, and hence was forced to take the only step left with it – ask banks to give their money for free.

RBI hiked the cash reserve ratio (CRR) over the weekend to 100 percent on the increase in net demand and time liabilities (NDTL) on cash accrued between September 16 and November 11. This measure is expected to continue till December 9. Normally, hiking CRR signals a tightening in lending rates, but that is the last thing the government or the central bank would like to do .

The RBI had little choice as banks were slashing deposit rates sharply. SBI, the largest bank in the country, cut bulk deposit rates to 3.75 percent on the 7-45 days deposit, a cut of 125 basis points. On the 180-210 days deposits, interest rates were cut by 190 basis points to 3.85 percent. Bulk deposits account for 8 percent of all deposits for the bank. Clearly, banks were struggling with the flow in deposits.

According to Edelweiss the new measure is expected to have a cumulative impact of around Rs 700 crore on banks’ profitability. The move will result in Rs 3.24 lakh crore of liquidity being sucked out. This is equivalent to the NDTL in a scheduled bank during the period mentioned by RBI. The move is likely to dent the treasury profit of the banks because yields have started rising.

After a gap down opening, banking indices have moved higher. However, whether the rally sustains will depend on RBI’s decision on December 9 when it decides to revisit the current CRR hike. Markets might not be as forgiving if the central bank continues with the CRR hike. The government and the RBI need the economy to start using the money collected; they will only do so if there is a sharp drop in interest rates. Every other measure will act like a band-aid to a chronic illness.