A. Seshan: Increase CRR to counter Fed rate cut

The Fed's decision to lower the overnight inter-bank rate will have wide ramifications for India.

The US Federal Reserve (Fed) has taken the decision to lower its target for the Federal Funds Rate (FFR) from 5.25 per cent to 4.75 per cent, besides cutting down the Discount Rate. FFR is the rate at which commercial banks borrow from each other in the overnight market through the medium of the balances (federal funds) they keep at the Fed. A look at the time-series comparing the actual weighted rates in the market with the targeted ones show that generally the Fed is successful in its operations.

The decision to lower the target for FFR has worldwide ramifications and India is no exception since it is now increasingly getting integrated with international financial markets. There have been considerable inflows of funds into India in the recent period due to the wide differences in the rates of interest prevailing here and abroad. This will get aggravated. The yen carry-trade is a clear manifestation of this. It takes advantage of the arbitrage opportunity available for borrowing funds in Japanese yen at near-zero rates and investing in other countries, including India, at higher rates, thus making tidy profits even after hedging till such time that the exchange rate turns adverse to an extent, making it no longer worthwhile. There could be a diversion of such trade from US to India. The attraction for inflows in general is reinforced by the resumption of the steady trend in the appreciation of the rupee against major currencies after a brief break due to the sub-prime mortgage crisis in the West. As of September 7, 2007, the year-on-year appreciations of the rupee (in per cent) were 13.24, 6.14 and 11.71, in respect of the dollar, euro and yen, respectively. There may not be any impact on the inflow of banking capital to take advantage of the high RR rate as there are quantitative restrictions on overseas borrowing by banks. Banks having foreign presence need to comply with the Basel II regulations by March 2008. They can raise up to 49 per cent of the eligible perpetual bonds and upper tier-II issuances from overseas. The decline in interest rates in the US may provide an incentive to banks to take to this route. RBI will have a busy time in protecting the turf of the Indian exporter. Market intervention would have to be followed by sterilisation which means an interest cost to government besides the quasi-fiscal cost implied in investing the mopped-up dollars in international markets at lower rates. The straightforward course would be to raise the Cash Reserve Ratio (CRR) following the example of China, where it is 12.5 per cent now. Of course, its problem lies in the ever-rising current account surpluses whereas in our case it is the capital flow.

From the beginning of the reform period, RBI was echoing the opinion of the Western economists that CRR is a form of "financial repression" by way of a tax on banks and should be given up in favour of indirect market instruments like the open market operations. The reduction of CRR to the minimum level of 3 per cent prescribed in law used to be a mandatory medium-term objective of RBI mentioned in every statement on monetary policy. Of course, the law has been amended to abolish even the minimum giving the hope to banks that one day India will be like Canada where there is no CRR. But this is not likely to happen in the near future. The RBI has recently stopped referring to the above-mentioned objective even for the sake of pro forma. Perhaps it is now a long-term objective! What is more, the governor of the Bank has clearly stated that it would use all the instruments at its command "" direct as well as indirect "" to deal with problems of money supply. (As this writer has argued on many occasions, the CRR is not a tax but a fee charged for the licence or privilege given to the banking system to manufacture money and derive seigniorage and hence legitimate). Of course, its incidence may be borne by the depositor and the borrower. The growth of money supply and reserve money are still too high to be of any comfort to the central bank being 20 per cent and 25.1 per cent, respectively, over the year, as of August 31, 2007. Non-food credit has, no doubt, decelerated but whether it is a temporary blip on the radar needs to be seen. The ongoing festival season may result in a revival of consumer credit, which saw an absolute decline recently.

Since elections are looming in the horizon, any rise in interest rates to deal with surplus liquidity may not be viewed favourably by government. Also it will be counter-productive, attracting further inflows. CRR is a neat option. The common man does not understand it and, hence, from the point of view of public relations too, it is better than raising the rate. Will not the hike in interest-free cash reserves lead to an increase in interest rates? In the normal course, it should but it may not for the following reasons: There has been a deceleration in the growth of credit due to the past increases in the rate of interest and some banks have even reduced them in retail loans. Further, the big corporates constituting the creamy layer of the bank clientele will increasingly turn to the foreign markets for External Commercial Borrowings (ECBs) for projects at lower rates making it difficult for our banks to raise their rates.

On the eve of the hike in CRR (August 4), the system had an excess cash reserve of 2.72 per cent. So it could absorb the 50 basis-point increase in CRR without any difficulty. As a result, it came down to 0.95 per cent on August 17. It went up to 1.6 basis points, as of August 31, on which no interest is earned. After reckoning the fact that bankers' deposits serve the purpose of not only CRR but also settlement of inter-bank operations any further rise in CRR could still be absorbed without difficulty. The call money market has been steady; its rate being close to the Reverse Repo rate of 6 per cent. During the tax payment period of March 2007 there were wide gyrations in the call money rates rising up to even 80 per cent on one occasion. On the other hand, recently the second installment of advance tax payments passed off peacefully.

The decline in inflation, the subject of official hype, is a false trail. Even, according to the latest data, while the Wholesale Price Index recorded a rise of 3.5 per cent over the year, that of the primary articles group was much higher. We may have to wait for the more recent Consumer Price Indices for various sections of society to get the correct picture.

Vested interests will argue that RBI should cut interest rates in line with the Fed decision to make India less attractive for the inflow of hot money. They will also cite the lower growth figures of Index of Industrial Production for July 2007. There is still satisfactory growth in the economy although it has decelerated. But then was it not the intention of the central bank to prevent the overheating of the economy?