RBI 30th July 2013 policy review has gained high significance on the back of its actions in the last few days. The central bank has sent confusing signals to the market by first announcing liquidity tightening measures and then taking steps to prevent bond yields from rising.
The markets are now worried on whether the central bank will hike CRR (Cash Reserve Ratio) to suck out liquidity and push up overnight money market rates. Markets are also worried of possible repo rate hike by the central bank that could signal a reversal of policy stance that saw the RBI reducing the repo rate by 125bps since April 2012.
The bravest of the brave will not try to confidently predict what the RBI will do on the 30th of July as the 15th July tightening measures announced late in the evening took markets completely by surprise. Money and bond markets turned extremely volatile with yields shooting up by 60bps to 150bps across the curve. Markets are nervous and will not take any directional position going into the policy.
We can however analyse each policy tool of the RBI and see what effect it will achieve to meet RBI’s goals. Let us take the CRR first.
CRR is a liquidity tool for the RBI and hiking or lowering the CRR tightens or eases system liquidity, as banks have to park more or less cash with the RBI. CRR balances do not earn any interest for banks and hence lower CRR leads to higher profitability and vice versa for banks.
The CRR rate is 4% and has been lowered by 200bps from 6% levels seen in May 2011. Liquidity as measured by bids in the LAF (Liquidity Adjustment Facility) auction of the RBI has been in deficit despite the 200bps fall in CRR indicating that liquidity deficit was structural in nature and had to be addressed through CRR cuts. Other measures of liquidity including deposit and credit growth and broad money supply (M3) have come off from levels of 18%, 22% and 17% to levels of 13.5%, 13.5% and 12.2% over the last two years. CRR cuts have only helped contain liquidity from going into deep negative territory and have not in any way led to a liquidity overhang in the system.
RBI by hiking CRR can only deepen a structural liquidity issue and this could lead to banks hiking rates for its customers as it increases cost of funds for the banks. The government is trying to get banks to lower rates for customers to help the economy grow and will not want to see banks hiking rates. RBI will think very carefully on the consequences of a CRR hike.
The probability of a CRR hike is low and if it does happen the consequences will be severe for the market and the economy.
The Repo rate is a signalling tool on direction of long term interest rates. RBI has lowered the repo rate, which is the rate at which it lends funds to the system, by 125bps since April 2012. A repo rate hike at this juncture is a signal that the Central Bank is reversing its monetary stance from accommodative to tight. Government bond yields will rise sharply on a repo rate hike leading to government borrowing becoming costlier. A fiscally constrained government will not want to pay higher borrowing costs at a time when the economy is slowing down sharply as GDP growth was at decade lows in the last fiscal year.
RBI too indicated that it did not want bond yields trending higher when it partly devolved the 19th July bond auction on the primary dealers.
Economic growth indicators such as IIP (Index of Industrial Production), domestic vehicle sales, corporate results and credit growth are weak and RBI will not want to signal an anti growth stance at this juncture.
The probability of a repo rate hike is low and if there is a hike the consequences will be severe.
The other tool RBI has on liquidity is SLR (Statutory Liquidity Ratio), which is the amount of government bonds that banks have to compulsorily hold as reserves. The SLR rate is 23% and a hike in SLR will lead to banks parking more funds in government bonds leading to liquidity being taken out of the system. SLR rate is at 23% and has come off from 25% levels over the last few years. RBI is keen on slowly lowering the SLR rate for banks to use funds more productively and would think many times before raising the SLR rate.
The probability of a SLR hike is low but if it does occur bond yields may actually fall, as banks will have to buy more government bonds as reserves. However given that banks holdings of government bonds are anyway 3% to 4% over SLR rate of 23%, a SLR rate hike may not have much of an impact on liquidity as well as bond yields.
The probability of CRR, Repo and SLR rate hike is low but possibility always exists, as conditions are not normal.