The Reserve Bank of India's third quarter review of monetary policy was devoid of major surprises. The only change in monetary policy instruments — a cut in the Cash Reserve Ratio (CRR) by 0.50 percentage point to 5.5 per cent — was largely expected.
The move will release Rs.32,000 crore of funds impounded from banks, almost immediately. The key policy interest rate, the repo rate, remains unchanged at 8.5 per cent. Consequently, the reverse repo stays at 7.5 per cent and the marginal standing facility at 9.5 per cent.
A cut in the repo rate would have more definitely indicated a downward shift in the monetary stance but the RBI has argued that the CRR reduction is the best it could do under the prevailing circumstances and ought to be interpreted as a signal for a softer monetary policy regime.
According to the RBI, the CRR is a policy instrument with liquidity dimension. Its reduction will bring down the cost of money for banks and have a bearing on their ability to lend at lower rates. It may well be so but, for most market participants, a repo rate reduction would be the more authentic signal. Soon after the policy announcement on Tuesday, attention has immediately shifted to how soon the RBI will act in that direction.
The RBI has cited three well known reasons in support of its latest stance. Economic growth is decelerating due to the combined impact of uncertain global environment, cumulative effect of past monetary tightening and domestic policy uncertainty.
(a) While some slowdown in the growth of demand was expected as a result of earlier monetary policy moves to control inflation, at this juncture risks to growth have increased.
(b) The fall in WPI inflation is due to a sharp decline in the prices of seasonal vegetables. However, protein-based food items and non-manufactured food inflation remain high. Further, there are many upside risks to inflation. Global petroleum prices remain high. The lingering effect of recent rupee depreciation continues and there is a significant slippage in the fiscal deficit.
(c) Liquidity conditions have remained tight beyond the comfort zone of the RBI despite massive infusions through open market operations.
All these have tied RBI's hands and postponed its decision to cut the repo rate. Less clear is what the half a percentage point cut in the CRR will do to ease liquidity as a critical step towards making banks lend more. Some analysts, notably A. Seshan (former senior RBI official), see an inherent contradiction in the policy statement: how does a situation of liquidity shortage co-exist with low credit offtake from the banking system?
‘A crowding out' effect
Consider the following: Money supply has been on expected lines but non-food credit growth at 15.7 per cent has been below the indicative projection of 18 per cent. The latter is due to the combined impact of a slowing economy and risk aversion among banks concerned over non-performing assets (NPAs). There is also ‘a crowding out' effect of increased government borrowing. Net credit to government has increased at a significantly higher rate of 24.4 per cent as compared with 17.3 per cent last year. The last point may be one of the reasons to explain the tightness in the money market. But the RBI has done its bit to ease liquidity by buying back dated securities, for instance. Far more difficult it is to reconcile low credit offtake with liquidity shortage.
The only explanation is that banks have become even more shy of lending than is apparent. As pointed out earlier, an increase in the NPAs does contribute to increased risk aversion among banks. There is also a widespread fear psychosis: the bona fide commercial decisions of bankers are being questioned many, many years later.
Power sector in deep trouble
A number of infrastructure sectors, especially power, are mired in deep financial troubles.
Telecom is in a mess. More recently, Kingfisher Airlines and Air India have shown how deep-seated the financial problems are even in a sunrise sector such as civil aviation.
Aversion to lending
Many times in the past too, risk aversion on the part of banks has been cited to explain the fall in lending. Given the dominance of government banks, it is of utmost importance to put in place a system of accountability, which will not penalise risk-taking.
In short, the RBI's betting on a CRR cut as a means of assuaging the disappointment over the absence of more overt repo rate reduction might have paid off in the short run. Stock markets are up. But for the CRR cut draws attention to some structural blocks such as risk aversion that will limit its potential.