The Curious Case Of RBI’s Monetary Policy Review

Posted in Finance Articles, Total Reads: 2349 , Published on 23 August 2012

On 31st of July, the RBI Governor, Mr. Subbarao silenced the markets for the second time in a row by acting against the market’s expectations by keeping the key rates – repo, CRR and bank rates – constant while cutting the SLR to 23% from 24%. Did that imply that all the analysis driven expectations by the various financial services firms were actually wrong?

On the first look it might be completely irrational from a banker’s perspective when they had been lobbying for a cut in rates which they believed as the only way to boost the market sentiments. This article provides another perspective as to why RBI was correct and other were wrong.

A Firm Stance:

As stated in one of his popular speeches the present impossible trinity post the 2008 Global crisis is finding a balance between Price Stability, Financial Stability and Sovereign Debt Consolidation. The annual policy statement for this financial year clearly has enough statements to see the importance attributed to which of the three components.

In the last policy review meeting, the Governor had clearly mentioned that inflation is a retrogressive tax imposed on the poor. This statement had made it very clear that financial stability and growth are more of a responsibility of the central Government than that of the central bank. Also, with macroeconomic conditions seemingly appear quite unfavorable, it actually makes sense to see the central bank sticking to its stance on price stability over financial stability.

But, if the inflation had moderated to 7.25% in the month of June, which was much closer to the RBI’s comfort levels, why would it prefer not to act aggressively by cutting the rates to boost sentiments? This is a question only if the Governor’s statement on inflation as a retrogressive tax is seen not till the end. According to him, it was not a retrogressive tax on everyone but only on the poor.

Thus, with monsoons, this year, disappointing to a great extent, food inflation already hovering above 10% and the Government very close to implementing the Food security bill at the end of year which would obviously stoke inflationary pressures on the food prices, it actually makes sense on the part of RBI to have enough ammunition on its side to cut rates in Q3. Thus it chose not to waste by needlessly cutting the rates when even the trend growth rate has fallen to 7%.

Volume of money:

However, it is also equally important for the central bank to manage market’s expectations when the sentiments are lying at the rock bottom. A slight look at the call rates over the past few days suggest that the call rates are slowly inching down towards repo rates so much so that, on 26th July, it even fell marginally below the repo rate to 7.95%. This event had sent an effective signal discounting the possibility of a rate cut as the fall in call rates signified excess liquidity in the system.

But, the question over the reason behind excess liquidity could be answered by the lack of investment avenues both from the lenders’ and the investors’ perspective. With increasing debt restructuring requests and rising NPAs only justify the passive mood in the banks’ investment offices. Thus, the CRR, which signifies the volume of money in the system, had no reason to see a cut.

Also, CRR is not the only way to manage the liquidity as the objective can be met through OMOs as well. And, on July 18th, the 10-year bond yields rose to 8.44% seeing lack of possible OMOs in the immediate future. Thus, there is an increased possibility of another OMO coming up in the next few weeks to not just bring the yields down but also the liquidity.But, another statement from the Governor’s end says another thing which refutes the above possibility.

Read between the lines:

According to his statement, issued on 1st August, RBI would go in for OMOs only to manage liquidity and not to manage Government’s bond yields. But, seeing the inaction from the fiscal front, the statement had as much political sense as economic sense.

Also, by cutting the GDP growth forecast to 6.5% it only had put pressure on the Government in a series of similar acts that it had been engaging to urge the passive office at New Delhi to urge into action.

The sound of a cut:

Now comes the Rs.40000 crores question. If the liquidity is comfortably well, then why would it go for a cut in SLR requirements by as much as 100 basis points? Frankly, it is an action only to answer the market makers who were mindlessly lobbying for a rate cut – it did not matter which rate it might be. The cost of money would obviously come down when the volume of money is sufficient enough. Thus, the RBI had no reason to cut the repo or CRR to bring down the cost and volume of money respectively. Thus, the logic behind their persuasion was nothing but a dubious call and of late it has become a habit to ask for a rate cut even when there is not any crucial need of the same.

The banks already maintain SLR levels of 28-30% to ensure that they have enough securities under their disposal to meet their collateral requirements to borrow from RBI through repo window.

Thus, a cut in SLR would not make any change in the liquidity but the ‘sound’ of a cut is loud enough to silence the irrational calls.

Thus, if the market makers were to be right in their future calls on the RBI’s monetary policy, either they should start reading between the lines of the statements coming out of the central bank’s office or say the obvious what their analysis suggests!

This article has been authored by Rajesh Dharmarajan from SIMSR.

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