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 fiscal 2011-12 has come off to 6.9% from growth of 8.4% seen in fiscal 2010-11. Monetary aggregates of deposit, credit and broad money supply (M3) growth for fiscal 2011-12 has also come off by 2.2%, 5.3% and 2.9% respectively from growth rates seen in 2010-11. Table 1 gives the growth rates of monetary aggregates over a ten year period.
The correlation of GDP growth to growth in monetary aggregates is high as seen in the 2005-06 to 2008-09 period where GDP growth of over 9% was accompanied by healthy growth rates in monetary aggregates with deposit, credit and M3 growing by 21%, 27% and 20% respectively. GDP growth in the subsequent period has fallen to below 9% levels and so has growth in monetary aggregates as seen in Table 1. The fiscal 2011-12 period has seen the slowest growth in bank deposit and M3 since the year 2004-05.
The sharp fall in monetary aggregate growth in 2011-12 has shown up in system liquidity tightness. Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) of the RBI has consistently been in negative territory throughout fiscal 2011-12. Liquidity deficit peaked on the 26th of March 2012 when banks borrowed a record Rs 195,000 crores from the RBI. Liquidity has tightened despite RBI infusing Rs 220,000 crores into the system through purchase of government bonds (Rs 140,000 crores) and lowering the CRR (Cash Reserve Ratio) rate from 6% to 4.75%, which released Rs 80,000 crores into the system.
Two factors that have negated RBI’s liquidity infusion are 1) RBI sales of USD of around Rs 100,000 crores and B) notes in circulation going up by Rs 115,000 crores. RBI in effect has only put in to the system the liquidity that has been sucked out of the system. The bigger picture of the structural liquidity deficit caused by a fall in monetary aggregates has not been addressed.
It is critical that RBI addresses the structural liquidity changes in fiscal 2012-13 if the government wants to achieve a GDP growth of 7.6%. The fact that the government is planning to borrow a net of Rs 479,000 crores from the market to fund its fiscal deficit of 5.1% 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 worth 38% of their incremental deposits in fiscal 2011-12, well above the statutory limit of 24%. 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 to address the structural liquidity change?
On the monetary side, RBI can infuse liquidity into the system by a) reducing CRR b) buying government bonds c) lowering SLR (Statutory Liquidity Ratio). CRR rate at present is 4.75% and RBI’s medium term objective for CRR is 3%. RBI may not want to reduce CRR to 3% given issues of inflation and it will cut CRR by 75bps to 4% in 2012-12. The 75bps CRR cut will add around Rs 50,000 crores of liquidity into the system.
RBI 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 RBI buys government bonds it will do so.
The large borrowing program of the government makes a 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.
RBI has the option of buying US Dollars (USD) to infuse liquidity into the system. The conditions for buying USD are not conducive as the Indian Rupee (INR) is trading at 15% below highs seen in calendar 2011. RBI will buy USD only when there are sustained portfolio flows into the country leading to the INR strengthening sharply.
Rate cuts are necessary to negate effects of tight liquidity
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 it 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 later the RBI postpones a repo rate cut, the later the easing of liquidity conditions.
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 a 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 in running will depress market sentiments sharply. Depressed market sentiments lead to rising bond yields, which is not the right ingredient for achieving higher growth rates.