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Monday, October 20, 2008

What should the RBI do?

The Reserve Bank of India (RBI) has been on a mission to inject more liquidity into the financial markets, especially through sharp cuts in Cash Reserve Ratio (CRR) and increased exercise of its Liquidity Adjustment Facility (LAF) window. All these are extraordinary monetary policy steps by the RBI.

The CRR, the proportion of their deposits that banks have to maintain in cash with the RBI, has been cut thrice from 9.5% to 6.5%, including one cut by 150 basis points. Statutory Liquidity Ratio (SLR), the share of assets kept in government securities, has been cut by 50 basis points. Besides this, the RBI has agreed to provide Rs 25,000 Cr to banks that have participated in the agriculture debt relief and waiver scheme.

Apart from the LAF auctions that permit banks to borrow from the RBI in return for government securities, the RBI has also decided to open a Rs 20,000 Cr credit window for banks to borrow from it in order to lend to mutual funds. All these have had the effect of releasing atleast Rs 1,45,000 Cr of lending resources to banks. Amidst all this action, the RBI has been conspicuously silent about the premier monetary policy lever - interest rates.

The unprecedented nature of the response, with the slew of measures to inject liquidity into the banking system, gives the impression of a crisis ridden banking sector. However, I am inclined to believe that both the diagnosis and the prescription may be a case of mistaking the trees for the woods. While an adequate CRR response was urgently warranted, the more important monetary policy exercise has to be by way of cuts in the interest rates. Unfortunately, action in this direction has not been forthcoming and delay may yet cost us dearly.

The liquidity problems facing the Indian financial markets and banks are not solvency related, but more a manifestation of the contagion effects from the global crisis. The global financial meltdown has triggered off massive unwinding of positions or deleveraging by FIIs as they repatriate capital to shore up the reserves of their embattled parents in US and Europe. This pullout and the apprehensions it generated has had a cascading downward effect on our equity markets. These investors have withdrawn more than $10 bn from the Indian equity markets in the past few days.

The effect of all these were amplified by the steep rise in margin and other prudential requirements imposed on financial institutions by mark to market (MTM) accounting procedures used to value the financial transactions they had indulged in. While such MTM accounting procedures had inflated the holdings during the bubble, they have had the opposite effect when the markets were falling. The result of all this was to have institutions scrambling to shore up their liquidity positions and reserves.

Further, the demand for dollars from FIIs pulling out their investments and oil importers looking to fund their oil purchases, has had the effect of temporarily putting upward pressure on the dollar. In other words, the Indian markets have not been spared the inevitable contagion effects of the turmoil in the global financial markets in the aftermath of the bursting of the sub-prime bubble in the US.

Unlike the US and European banking system, Indian banks do not suffer from any solvency crisis. The exposure of Indian banks to real estate and home mortgages is minimal when compared to those in US and Europe. Further, the capital adequacy ratios (CAR) of all the major Indian public and private sector banks are higher than the Basel II requirement of 12%. Therefore, at worst, we have a temporary liquidity crisis created by the sudden exodus by the FIIs and the contagion effect of the global financial market turmoil. The fundamentals of the real economy is sound and in any case has not deteriorated significantly over the past few weeks to merit any dramatic response.

The Indian corporates are facing a credit squeeze not because of any lack of adequate liquidity, but because of unaffordably high cost of capital. The pall of gloom hanging across the global economy and the expectations of an impending slowdown in the Indian economy, have exacerbated the investment climate. In this environment, the high interest rates act as a sure shot tranquilizer.

The steep falls in global energy and commodity prices and the attendant declines in domestic inflation removes the only remaining rationale for keeping interest rates high. Our interest rates are one of the highest among all major economies, and we are the only one to have not loosened monetary policy in the past few days.

The huge off-balance sheet deficits, in the form of oil and fertilizer bonds, limits the ability of the government to indulge in any fiscal pump priming, either by way of infrastructure spending or tax concessions. Fiscal policy becomes constrained under the conditions, leaving monetary policy to shoulder the responsibility.

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