Should the RBI cut the CRR today?

There is little doubt it will help improve liquidity which is really tight, though there is the question as to whether this is enough.

Ajay Mahajan,
President, Financial Markets, Yes Bank

"Liquidity is expected to improve in April-May, but the fear of inflation rising is real, especially with high asset prices, so a cut doesn't make sense."

As we approach the 2006-07 Annual Credit Policy, the primary question is whether the RBI will cut the credit reserve ratio (CRR). Broad economic conditions continue to be strong and the credit-deposit ratio is at an all time high at 72 per cent, with the incremental credit-deposit ratio for FY2005-06 in excess of 100 per cent.

However, is a CRR cut, as a resort to meet credit needs, justified at this juncture? We believe not. There are four main reasons that lead us to this belief:

First is the aggressive central bank intervention in the foreign exchange market. The policy response to the receding liquidity that followed the India Millenium Deposits (IMD) redemptions was addressed through MSS unwinding and through RBI action in the forex markets, which serves the dual purpose of managing liquidity and, at the same time, holds the real effective exchange rate to a more acceptable level. We do not expect to see a change in this stance.

Liquidity for the first half of the current fiscal year is seen improving on coupons and redemptions. Redemptions and coupons (including MSS) of about Rs 107,000 crore accrue during the first half of FY 2006-07. Moreover, liquidity is expected to improve in April-May as the government spending trickles back into the banking system. This should take care of the government's borrowing programme, slated at Rs 89,000 crore for the first half of the fiscal.

The risk of increasing money supply has the potential for stoking inflationary pressures. Inflation has been low for the past few months but the CRB commodity price index has advanced 4.8 per cent since the start of this calendar year.

The RBI cannot risk excess liquidity conditions at a time when central banks across the globe are on a tightening mode, with the Bank of England being the most prominent exception. The Federal Open Market Committee is likely to deliver its 16th consecutive hike in May. Furthermore, with the Indian economy currently on a self-propelling growth momentum, the need for easy monetary support is not as crucial.

The overall exposure of banks in the housing sector has been growing and constitutes a significant portion of their total incremental credit portfolio (housing loans have grown 50 per cent in 2004-05). Currency with the public has risen Rs 62,873 crore on a year-to-date basis, an increase of nearly 18 per cent over the previous year. While this rise in currency demand has contributed to an outflow of money from the system, it is also a result of the boom in the asset markets. With some concerns about asset prices building, the RBI would not want easy money conditions to result in inferior credit decisions.

The aforementioned factors clearly deny the leeway for increasing money supply. With apprehensions regarding the potential increase in inflation emanating from excessive money creation, and with high asset prices looming large, the RBI is unlikely to proceed with a CRR cut.

In sum, the RBI is expected to maintain its stance on CRR and remain firm on maintaining adequate liquidity to meet genuine credit needs, especially since the central bank is seriously concerned about credit quality and has been repeatedly highlighting concerns on asset price pressures.

Ravindra Kumar,
Country Head, Wholesale Banking, ING Vysya Bank

"While more structural changes such as allowing banks to fix savings rates are needed, a CRR cut is an effective short-term solution."

About a year ago when I had an opinion on the interest rates hardening in India and liquidity getting tight before March 2006, I found myself in a minority amongst the bankers in town. Last year we had an excess liquidity of around Rs 25,000 crore in the banking system, which has expectedly disappeared on account of three reasons:

Net outflow on account of India Millenium Deposits redemptions. It is estimated that while around $2 to $3 billion has found its way back in the banking system, the rest is still floating outside of it.

A good pick-up in credit demand in economy, thanks to a sustained industrial growth of around 8 per cent, and also since the level of disintermedation in the bank lending market has reduced, thanks to renewed vigour of equity funds as against debt funds. This has pushed the credit-deposit (CD) ratio of most of the banks in India to beyond 70 per cent.

Increasing the diversion of savings into real estate and equities due to an unprecedented bull run that we are currently witnessing.

The net result is an extremely tight liquidity situation in the banking system and shrinking net lendable resources. Interest rates are running high at the short end while banks are falling head over heels to fix their CD ratios. There is a popular counter theory that all the above will still keep the money circulating within the banking system "" so why all this noise? It's true that to some extent the money gets recirculated, but every outflow from the banking system for any outside bank deployment brings in a "diffusion impact" Now the big question is: when and how do we see the condition improving?

While there is active debate going on about the impending CRR cut, we need to analyse if this is the only and a sustainable way out. My opinion is that it is only an ad hoc measure although quite effective in the short-term. The Reserve Bank of India (RBI) has so far managed the overall situation well and will live up to its role of stabilising the market once again. I do not want to hazard a guess about what percentage cut will be effected, although a 1 per cent cut will help the situation a lot more, albeit the more probable scenario is 50 basis points.

However, a word of caution here: the market is looking forward to a few more structural measures such as relaxation of ECB norms to bring in higher foreign currency funds, providing freedom to the banks to fix savings bank rates and provide tax incentives on bank fixed deposits. The recent relief provided in the Budget for long-term fixed deposits is a welcome move, however, the banks need more, I am afraid. Till then the buzzword should be: Run a tight ship and have higher frequency of ALCO reviews.

The past week or so has seen a little bit of inflows back into the banking system, however, there is no visibility on its long-term sustainability. While the cash generations of India Inc will, over a period of time, find their way into the banking channels, there is a clear demand for brining bank deposits on par with other savings instruments in fiscal incentives, otherwise the bank deposits growth will remain rather sluggish.