Abheek Barua: On the perils of plenty

For domestic borrowers, the worst times might just be over. For depositors the party might have just ended.

The problems of plenty have come to haunt the Indian money markets yet again. On July 6, to take an example, banks were willing to place as much as about Rs 90,000 crore in the Reserve Bank of India's (RBI's) reverse repo window. While the cap of Rs 3,000 crore (on funds that can be accommodated in this facility) meant that only a minuscule fraction of the total amount bid was actually accepted by the RBI, it gives a sense of the quantum of surplus funds lying with banks. Other days have seen a similar surplus. The consequence: call money rates (the price of overnight loans) have plummeted to levels of less than 1 per cent. Banks are finding it difficult to get borrowers, particularly for short-term loans, and some have quietly started cutting rates. The interest rate cycle in India seems to have, without much fanfare, reached a peak.

Much of this surge in liquidity has been driven by persistent intervention in the foreign exchange market""the RBI has bought dollars to stop the rupee's northward journey, releasing rupees into the system. This has coincided with some other developments that have buttressed banking liquidity. For one, the demand for credit has come down sharply as high loan rates have bitten into the demand for retail loans. It is also likely that the central government is on a spending spree as infrastructure and other projects that had been languishing on the drawing board are finally seeing the light of day. A rise in government expenditure implies that more rupees flow through the monetary sluices, shoring up liquidity in the process. State governments are sitting on huge piles of cash. If they, too, were to loosen the purse strings, the cash surplus in the system could go even higher.

While the RBI has seemed comfortable with the build-up in liquidity over the past month, it is unlikely that it can let the situation persist for long. The risks are somewhat obvious. Inflation rates may be low now but persistent excess is known to have the habit of breeding inflationary expectations. The somewhat insidious but rapid rise in oil prices needs to be borne in mind in this context.

The more immediate and tangible risk is the possibility of a reversal in the credit cycle. If banks have access to funds at low rates, they are likely to cut their lending rates and push up asset growth. Banks face competition in the corporate loan market from external borrowings and thus the most rational strategy would be to seek retail borrowers. Thus, credit growth rates might start moving up and retail assets might have a disproportionate share in the up-tick. Both would seem to go against the objectives that the RBI set out in its monetary policy announcements of the past year""that of moderation in credit off-take with a specific focus on cooling retail credit demand down.

What can the RBI do? I am honestly a little surprised that the central bank has not used the Monetary Stabilisation Scheme (MSS) facility a little more aggressively. These are incidentally bonds that are issued only for the purpose of draining liquidity from the system. Perhaps the RBI has a more permanent policy measure in mind in tackling rates.

The twist in the tale comes from the currency market, where the rupee is steadily gaining against the dollar as foreign capital keeps pouring in. Any sharp increase in interest rates would add to the problem since a larger difference in interest rates between local and global markets induces arbitrage seeking capital inflows. This, in my opinion, would rule out the possibility of removing the cap on reverse repo bids. The reverse repo facility effectively works like the administered pricing mechanism. By offering to borrow short-term funds from banks at the rate of 6 per cent, the RBI effectively prevents market forces from playing out and keeps short-term rates from falling. If the RBI does something here, it will have to be a little more nuanced. It could thus raise the cap a little and not remove it entirely. Alternatively it could lower the reverse repo rate and ease the limit. My sense is that, at this stage, it would be somewhat wary of signalling an explicit cut in policy rates.

This leaves us with the cash reserve ratio, which has emerged as the most effective instrument for liquidity management. This is the mandated fraction of banks' liabilities that it needs to hold as deposits with the RBI. It is currently at 6.5 per cent and could be moved up to 7 per cent either in the next monetary policy or even earlier. The advantage of a CRR increase is that it works dynamically. While the initial impact is to suck out a quantum of liquidity, it dampens the entire process of money creation that works through successive rounds of lending. Economists would refer to this as fall in the money multiplier.

A rise in the multiplier would have two effects. By signalling that it is not turning a blind eye to excess liquidity, it would dampen expectations that interest rates are in for a free fall. It would also nudge up rates at the shorter end a little and increase banks' cost of short-term funds.

That said, even with a hike in the CRR, medium and long-term bond yields are likely to soften from current levels. This will spill over to deposit and lending rates. For one, a hike in the CRR will certainly help stabilise the money markets but will not excise surplus liquidity entirely. In fact, the system might see considerable surplus if capital inflows continue. Besides, declining inflation will also pin rates down. For domestic borrowers, the worst times might just be over. For depositors the party might have just ended.

The author is chief economist, HDFC Bank. The views here are personal