Let me ask a trick question. How much has RBI hiked its policy rate this year? If your answer is one percentage point or a percentage point and a quarter (depending on whether you are referring to the repo or the reverse repo rate), you would be wrong. While the individual rates have been indeed hiked by that quantum since January, the banking system has moved from a liquidity surplus to a deficit from the end of May. From parking thousands of crores of surplus with RBI at the reverse repo rate, banks were at the time of the policy announcement last week borrowing equally large amounts from the central bank at the repo rate. Thus, while the effective policy rate was the reverse repo rate of 3.25 per cent in January, it is the repo rate of 5.75 per cent today. In short, the policy rate has moved up by a whopping two-and-a-quarter percentage points over 2010. RBI’s supporters would argue that the central bank hasn’t exactly been sleeping over inflation.
This liquidity deficit came about by accident, not by policy design. As telecom companies paid the government the charges for the 3G and broadband spectrum auctions, roughly Rs 1,00,000 crore left the banking system and went into the government’s account. This created a liquidity hole that banks tried to bridge by borrowing from RBI at the repo window. The initial response from the central bank was that this deficit was temporary and it would do its best to return the system to surplus.
The importance of last Tuesday’s monetary policy was RBI’s admission that it actually prefers this liquidity deficit to a surplus. It would, as a policy objective, keep the system in “injection mode” — that is ensure that banks keep borrowing from the central bank rather than lend to it. The logic is simple — for monetary policy to make a dent on inflation, policy signals have to translate into higher lending rates. (Tuesday’s policy statement incidentally jettisoned the usual waffle on the need to balance growth and inflation and clearly pointed out that inflation was the dominant concern). Then it should not quite take rocket science to figure out that banks are more likely to up deposit and lending rates if they are short of cash than if they are flush.
What are the implications? If indeed RBI wants to ensure a liquidity deficit rather than surplus, it will have to manage the quantum of liquidity directly rather than simply alter the policy rates. That means more active use of the cash reserve ratio, the fraction of deposits that banks are mandated to keep with RBI. Thus, if the liquidity impact of the auctions dissipates (at HDFC Bank we expect a small surplus in August), RBI could impound some of this cash by raising the cash reserve ratio and taking the system back to deficit. For banks, the strategic implications are a no-brainer. If liquidity is indeed likely to remain scarce and the central bank is also likely to raise the price of liquidity (the repo rate), the only thing to do is to hike deposit rates. Since banks are in the business of maximising profits, this makes sense only if they can protect margins and lend at higher rates. The bottom line is that there will be an immediate hike in deposit rates and lending rate increases will follow with a lag. This lag could be three months or even shorter.
Credit data show that there is much more traction in corporate loan demand than in retail. In fact, some of my colleagues on the retail side of our business complain of aggressive price wars fought between banks in retail markets. Thus, the initial rise in lending rates is likely to be for corporate loans and higher rates for retail loans will come later.
How much more should RBI hike rates? That depends on how much behind the curve the central bank finds itself at the moment. Recent comments by a senior RBI official (reported widely in the media) suggests that the central bank has fallen far behind. My colleague and committed econometrician Jyotinder Kaur runs a variant of the Taylor rule model that is widely used to determine a central bank’s optimal rate response to inflation and growth. Jyotin uses the difference of current inflation from the target of 5 per cent and the deviation of industrial growth from its underlying trend as explanatory variables. She concludes that RBI is less than 50 basis points below the curve if the repo rate is likely to continue to be effective policy rate. Thus, while a couple of more rate hikes are perhaps warranted if RBI wants to climb back on the curve, a more aggressive approach is perhaps unnecessary.
There are other caveats as well. In order to earn its kudos from the inflation hawks, RBI has suddenly jettisoned all other objectives that it was grappling with and returned to a textbook template. However, problems like instability in the global financial markets or the possibilities of a sudden stop in capital flows have not gone away. China and the western economies, particularly the US, are again beginning to look rather fragile. RBI needs to keep its antenna up for these risks and calibrate policy accordingly. Otherwise a full-on jihad on inflation through aggressive monetary policy could lead to undesirable collateral damage.
The author is chief economist, HDFC Bank. The views expressed are personal