Knock Knock RBI….. Are We Heading Right After The SLR Cut?

Posted in Finance Articles, Total Reads: 1783 , Published on 25 August 2012

According to Keynesian economics, demand equation states that aggregate demand (and the national income at equilibrium) is an algebraic sum of consumption demand, investment demand, government expenditure and net exports. The moment we say 'demand', it is backed by money and indicates a destination where people roll out their money. If this money is spent to satisfy any of these demands which add up to the national income, it’s a positive sign. The more this happens, more the country grows economically and more is the national income.

However, there is a flip side to it. In context of present Indian economy, if money is spent to fulfil consumption demand, this would result in price-rise and aggravate ‘inflation’. However, if money goes into investments and commencement of businesses, it triggers a set of demand sources and supply destinations, creating ‘new’ employment and adding to the income without causing inflation directly and intensely.

Figure: Distribution of money among demands

Consider an analogy, where we have a dam constructed with an aim to irrigate fields. It has water collected in the reservoir, which flows into fields through channels. Thus, it’s the channels which ensure that the water in the dam gets utilized for growing crops and not for domestic purposes of farmers' households. Had the channels being broken and had the water been routed to households instead of fields, crops could never have grown due to lack of water and production of the territory would have severely hit. Water, here, is equivalent to liquid rupee with Indians, crops to the GDP, and channels to the government regulations. Presently, major part of money (water) is spent in buying consumer goods (household demand) rather than investing (irrigating fields).

Now, why does it happen? Let’s look at it from a common man’s point of view. If I have Rs.100 today, I have two options:

  1. Purchase a consumer item(say a book) costing Rs. 100.
  2. 2. Invest in a bank or G-sec.

Figure: Why shall one invest?

With inflation rate=7% and interest rate=9% (assumed), price of book after an year would be Rs. 107. If invested, Rs. 100 turn into Rs. 109 after one year. If I delay my purchase of book by an year and invest Rs. 100, I get additional Rs. 2 then or a present value of 2/1.07=1.86. So, a wise decision is to invest now. Why NOT to invest?

With inflation rate=10% and interest rate=8% (assumed), the price of book after an year would be Rs. 110. If invested, Rs. 100 turn into Rs. 108 after one year.If I delay my purchase of book by an year, then I fall short by Rs. 2. So, a wise decision is to purchase it right now. Why to invest?

Imagine, in the second case, if the interest rates are still lowered to 7%, tendency to invest less and spend more shall be tremendous, fuelling inflation and plummeting investments. Unfortunately, current state of the economy is of the second case. Interest rates appear to be too low to encourage any investment in front of sky-scraping inflation.

This comes as a strong reason which held the RBI into a dilemma when it came to cutting interest rates. However, the recent announcement by RBI was a fantastic trick played. The objective behind cutting interest rates was to infuse liquid money into the market. To have an inflation-free growth, it was necessary to route this liquid money to investments rather than consumption spending. One pillar of the economy, which couldhave this done,was the Banking System.

Figure: Sources of money to lend for banks

For a bank, the figure shows typical source of lending money to businessmen. Observe that with x% margin almost constant, reducing r% can reduce this source of money for the banks making investment loans even tougher. This reflects the dependence of bank on deposits. RBI this time provided an alternate source of lending money to banks by freeing them of obligation of holding 24% NDTL in statutory investments by 1%. This was seen as a master-trick by the veteran Dr. Subbarao, and indeed it is, since it freed Rs. 65000cr. for banks to lend. Also, this completely bypassed the need to cut-down interest rates.

However, this move has some traps, which if unfold, can get RBI and the economy into serious trouble.Let’s have a closer look.

What’s the guarantee that the liquid money unveiled, would…..?

A day after cut in SLR by the Reserve Bank, State Bank of India has slashed lending rates on car loans by up to 0.5 per cent. This has to shoot demand for automobiles if players in banking segment follow this. If they don’t, they’ll lose business. If they do, we get into the chain of events pepping up consumption demand, triggering inflation.

As the prime regulator body, wasn’t this possibility apparent? What’s the guarantee that the liquid money unveiled would be diverted to quench the investment demand? It’s a matter of great importance and high uncertainty and probably shall invite another set of regulatory announcements from the supremo in recent future.

What might be the objective of RBI to have a policy which indirectlyputs the government in.…..?

The government is scheduled to borrow Rs. 1,21,000crore through bond auctions over next eight weeks, which of course means that it would ‘sell’ or ‘issue’ bonds soon. A decrease in SLR shall disentangle bonds to be traded in market and shall surge supply of bonds. Consequently, bond prices shall fall, which has already begun. This translates to a fact that bondsnow havebigger yield expectations from the investors in the market as compared to the time a week back. In light of this, if the government wishes to raise money through bonds, it has to pay higher returns, which shall be another headache for the heavily indebted Government.

To counter this, RBI was expected to come up with Open Market Operations, OMO, where to hold rising bond yields, it was expected to purchase bonds. However, Governor Mr. Subbarao stated that OMOs shall not be done to help GOI. OMOs would be done only to infuse/contract liquidity.

A recent bond-buying by RBI through OMO resulted in a flow of Rs. 82,500 crore in the market in the first quarter of this fiscal.

In the wake of these incidents, isn’t it an obviously expected clash between the GOI and the RBI? If not, and if RBI finally chooses to buy bonds, won’t it steepen the solvency issues of GoI? Wouldn’t the excess pumping of liquid money result into rise of price and inflate the market? If not, then how does the fragile seeming GoI-RBI team direct this additional money “again” into investments and not into consumption spending? And, if this lastshot goes haywire, this decision of lowering SLR shall be devastating. Have simply visible possibilities these been neglected by RBI? In a nutshell a question seeking an answer from the apex bankis,what might be the objective of RBI to have a policy which indirectly puts the government in troublesome state regarding raising money and repaying it?

But, are the banks really interested in……….?

Having a reality check reveals that the actual holdings of all banks in zero-risk government bonds is about 30%, much above the regulated compulsion (24%). This means that banks prefer to use their funds in investments over disbursing loans to corporates, the reason being a high probability of default.

So, what’s the relevance of reducing the mandatory SLR? Probably, time shall answer this better. It would take some time for banks to repose their faith back in private sector borrowers. Or it mayalso drill down to a stage where RBI will have to put a temporary upper cap as well on the g-sec investments by banks.

A slight indication of disinterest was reduction in interest rates of auto and home loans immediately after the announcement. A crucial concern, ahead of this herculean exercise by RBI to infuse “only productive” liquidity is, whether the banks are really interested in this growth mission of the nation?

However, a ray of hope here is that although the system as a whole has much higher bond holding than required, many small banks—foreign and private—do not have much leeway as their SLR holdings are just marginally more. They will benefit from the move as with a lower floor for SLR, they will have excess bond holdings against which they can borrow from the repo window.

In a situation with a dire need for economy growth, disappointing IIP statistic, high expectations from veteran Mr. Subbarao, soaring inflation, falling currency and political instability, its commendable that RBI finally dared to suffuse water in the farm to reap crops in terms of a higher GDP. However, it’s critical to see that the water is channelized to fields and not to the households. If the concerns discussed above are not attended by RBI, this village called India shall neither have crops nor the consumers to demand those.

This article has been authored by Vibhu Gangal from SCMHRD.

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