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Informist, Thursday, Dec. 5, 2024

By Siddharth Upasani

NEW DELHI - When it comes to interest rate decisions, the bar is always high for opinions to make a quick U-turn. One data-point, such as a spectacularly poor quarterly GDP growth number, does not really result in a complete re-writing of policymakers' assessment of the economy. As such, the Reserve Bank of India's Monetary Policy Committee is widely expected to leave the repo rate unchanged at 6.50% for the 11th meeting in a row and only cut the key policy rate in the post-Budget February meeting.

The ball, at present, is in the RBI's court after the committee in October laid the ground for lower interest rates by shifting its stance to neutral from withdrawal of accommodation. The central bank, then, must alter liquidity conditions accordingly. Instead, liquidity has tightened. According to the RBI's own calculations, the net durable liquidity surplus in the Indian banking system was at INR 1.89 trillion as on Nov. 15, less than half the INR 4.88 trillion it was at before the MPC met in October. It is no wonder then that markets are calling for the RBI to do what the MPC told it to by loosening its policy stance: ease liquidity conditions. And a reduction in the Cash Reserve Ratio is at the top of the list of asks.

According to ICICI Securities Primary Dealership's economists, a 50-basis-point reduction in the CRR in two steps over the next one month would be suitable given that it ensures a large liquidity injection "and the monetary nature of this tool that also provides a soft signal about direction of monetary policy in the coming quarters". Several others agree, with some even suggesting that a one-shot 50 bps cut in the ratio could be a possibility.

It is worth pointing out that the RBI had increased the CRR by 50 bps to 4.50% in May 2022 at the start of its rate hike cycle, resulting in the withdrawal of around INR 870 billion of liquidity from the banking system. A similar reduction would only take the CRR back to normal, pre-pandemic levels, and add around INR 1 trillion of liquidity.

ALL OPTIONS ON TABLE

To be sure, all options will be on the RBI's table, as the central bank often says. 

"CRR rates could be eased by 50 bps in December, Variable Rate Repo transactions could be increased, and gradual OMO (open market) purchases could follow soon," HSBC economists said in a note after last week's disastrous GDP data for Jul-Sept.

The RBI's huge interventions in the foreign exchange market to defend the rupee over the last couple of months--Goldman Sachs economists said last week the central bank's foreign exchange sales in the spot market have been around $46 billion since the end of September--have driven down banking system liquidity. Assuming Goldman Sachs' estimate is accurate, it amounts to more than INR 3.5 trillion of rupee liquidity being drained. Correcting this situation is crucial because transmission of any future repo rate cuts by banks would be faster and greater if liquidity conditions are easier.

What makes a CRR cut the most attractive option is the possible lack of efficacy when it comes to the other tools at the RBI's disposal. Long-term variable rate repo operations are unlikely to find many takers as we are, from all accounts, at the start of an easing cycle--no bank will want to borrow funds at more than 6.50% when the repo rate could be under 6.00% half a year later.

Open market purchases, it can be argued, could create a strange situation wherein there are only buyers in the government bond market: demand from banks is set to increase in the face of the revised Liquidity Coverage Ratio norms, while foreign investors may continue to lap up gilts as India's weight keeps rising in JP Morgan's indices and it gets added to those of Bloomberg and FTSE Russel in January and September, respectively. The demand-supply mismatch could get further accentuated if the central bank joins on the buying side.

THE RBI VIEW

If the past is any indicator, the RBI's assessment of liquidity conditions may be different from that of the market. For one, liquidity remains in surplus and a neutral policy stance does not necessarily mean improving liquidity conditions--although any future central bank interventions in the foreign exchange market could tighten the situation in the coming months.

Further, the RBI can also point out that government spending is on the rise.

"We think that it is early for the RBI to argue for a CRR cut as the government's expenditure pick-up could add to the liquidity and there is no clarity on the extent of FX sales that could be required in coming months," YES Bank economists said in a note on Tuesday.

In October, the Indian government’s expenditure was up 32% year-on-year.

All in all, the central bank has its plate full--either it acts or explains to markets why it does not need to should it think that liquidity conditions don't need to be eased. Whatever it chooses to do will not be straightforward.  End

US$1 = INR 84.73

Edited by Vandana Hingorani

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