Email
Print
ShareThe Reserve Bank of India (RBI) is fighting two demons simultaneously -- excessive systemic liquidity and rising inflation expectations.
Currently, there is a surplus of Rs300,000 crore in the system -- banks have parked Rs 150,000 crore with the RBI and Rs 150,000 crore with mutual funds.
Credit offtake remains feeble; credit growth is under 15%, while deposit growth is at a healthy 21%.
The copious liquidity is not flowing towards government bonds because banks are reluctant to take mark-to-market positions owing to worries over rising bond yields (or falling prices).
Ten-year benchmark yields have risen 250 basis points in 2009 to date despite the system being flush with cash, an accommodative monetary policy and low credit offtake.
The parking of excessive liquidity by banks in overnight instruments suggests that banks view the liquidity situation as temporary and that RBI is likely to suck out cash as inflation expectations rise.
Now what does the RBI see? Inflation expectations have risen due to rising food prices brought about by a weak monsoon.
Primary article inflation is trending at double-digit levels and is helping keep consumer price inflation at over 10% levels.
On the other hand, aggregate demand in the system is low with weak credit offtake and ten successive months of negative export growth.
Clearly, the central bank's liquidity measures are not helping the real economy nor is it helping keep down government borrowing costs.
Bond market participants are also anticipating RBI action to bring down systemic liquidity. That's keeping the jitterbugs aflutter on the Street.
In light of all this, it makes eminent sense for RBI to hike the cash reserve ratio (CRR) -- or use the so-called blunt weapon -- ASAP. A CRR hike in times of lazy banking does not hurt the system.
The steep yield curve with the reverse repo to ten-year government bond yield spread at 425 basis points will help the market shrug off any rise in yields at the short end of the curve.
The normalisation of systemic liquidity through a CRR hike will also bring down potential instability at the short end of the curve, where all the excess liquidity is currently parked.
And lower levels of systemic liquidity will also help prevent leakages into speculative activity.
In a sense a CRR hike will actually bring a sort of relief to the markets, which is grapping with liquidity coupled with uncertainty.
The RBI will also be seen as acting on potential inflationary pressures and bring down inflation expectations. A hike in statutory liquidity ratio (SLR) in conjunction with a hike in CRR makes sense at present. The banking system is suffering from bond fatigue because of the massive borrowing programme of the Centre and the states.
The sharp rise in bond yields is preventing them from taking on mark-to-market positions, while headroom for non-mark-to-market positions is almost zero. The government has to go through with their borrowings and they need banking system support.
An SLR hike is both a liquidity measure as well as a relief measure for banks suffering from mark-to-mark losses in supporting a huge government borrowing programme. Given that credit offtake is low and liquidity is expected to be ample even after CRR and SLR hikes, the move will actually help bring equilibrium to the system.
The sooner the RBI hikes CRR and SLR, the better for the market and the economy.
Disclaimer : The author is Head - Fixed Income IDFC Mutual Fund and views are personal.
