Gaurav Kapur
The monetary policy committee (MPC) is due to announce its decision after its first meeting for the fiscal year on Thursday. Macro-economic conditions suggest that the MPC would deliver at least another 25 basis points (bps) cut in the repo rate to support growth as inflation remains benign. Consumer price index (CPI) inflation is well below the 4 percent target with a stable outlook for next couple of quarters, while the latest estimate of gross domestic product (GDP) data showed that growth slowed down to 6.5 percent in second half of FY19 from 7.5 percent in the first.
In fact, growth concerns became more entrenched across the globe in the first quarter of calendar 2019, prompting a significantly dovish shift in monetary policy among the major global central banks. The US Federal Reserve has indicated that it would not be raising rates in 2019. Markets are even pricing in a small chance of a Fed rate cut later this year due to recession fears. In the February meeting, MPC members had flagged global slowdown as a concern for domestic activity through lower exports and investments.
The scope for further monetary easing through more rate cuts is therefore quite well established. Interest rate swaps are pricing in two more cuts in the repo rate over the next year from the current level of 6.25 percent. While rate cuts signal a dovish shift in the monetary policy, their transmission to other rates requires easing of liquidity conditions in the banking system. From the second quarter of the previous fiscal year, RBI has had to progressively infuse durable liquidity through the open market purchase of government bonds. A balance of payments deficit over the first three quarters of FY19 combined with an increase in currency in circulation led to tight liquidity conditions. Open market purchase of government bonds worth Rs 2,993 billion was done in FY2018-19 by the RBI to ease the liquidity constraint. In the last week of March, the RBI also introduced a new instrument to infuse rupee liquidity, through the USD-INR swap route. The swap auction injected almost Rs 350 billion for a 3-year period. The central bank over FY2018-19 thus used an array of instruments to manage liquidity—daily and term repo auctions, OMOs and USD-INR swap.
As we start the new financial year, the persistence of deficit liquidity condition, among other things, would slow the transmission of policy rates to broader rates in the economy. In view of such conditions persisting, there is a case to consider cutting the bank’s cash reserve ratio (CRR) requirement, which currently stands at 4 percent of the net demand and time liabilities (NDTL) by 25-50 bps, to hasten the pass-through of easier policy rates to lending and other rates.
While open market operations in the bond market are the main source of managing autonomous shifts in liquidity of a durable nature under the inflation targeting regime, there is a need to use other available tools too. For instance, a large open market bond purchases have raised concerns about monetisation of government deficit and keeping a lid on government borrowings cost at a time when the overall size of borrowings has been increasing. Market rates, on the other hand, have been sticky with the spread between government bond yields and other rates widening. The USD-INR swap window, while a useful alternative, may have to be used more judiciously in order to keep the cost of swap in check and to attract adequate investor participation. For instance, the first swap auction saw aggressive bidding without the RBI having to offer much of a discount on the premium payable. And, encouraged by that participation, RBI announced another $5 billion swap for April 23.
However, if there is regular use of the swap window, it may require a higher discount to be offered and may suffer from lack of interest from investors during times of global risk aversion. These considerations would weigh upon the liquidity management operations of the RBI in the new fiscal year.
The CRR was last cut in February 2013. Since then the monetary policy regime has formally shifted to target inflation by the use of repo rate as the policy signalling rate and the weighted average call money rate as the operating target rate. The RBI has thus moved away from using the CRR as a monetary tool under the new regime and has relied on instruments mentioned above to modulate liquidity in line with its monetary policy stance. In the meantime, over 2015-2019, liquidity coverage ratio (LCR) has come in full effect as a liquidity standard, following the 2010 recommendations of the Basel Committee on Banking Supervision (BCBS). Since January 1, 2019, banks now maintain an LCR of 100 percent, which requires them to hold high-quality liquid assets equivalent to total net expected cash outflows over the next 30 calendar days. The SLR too will be reduced to 18 percent by mid of 2020, from 19.25 percent currently and a carve-out is allowed from the SLR holdings to meet the LCR requirements.
These developments have created an enabling environment, where the CRR can be reduced by 25-50 bps, without compromising on the need to maintain adequate liquidity buffers. That would help in ensuring faster transmission of lower policy rates to lending and deposit rates, especially at a time when bank lending growth in picking up but deposit growth is lagging.
Indeed, the credit-deposit ratio is currently holding at the highest levels in five years. A 50 bps cut in the CRR would inject about Rs 640 billion of liquidity in the banking system, reduce the statutory cost of deposits for banks and help them reduce lending rates with a lower time lag in response to lower policy rates.
(The author is the chief economist of IndusInd Bank. Views are personal.)
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