In the first monetary policy statement for this financial year, Raghuram Rajan, the governor of the Reserve Bank of India(RBI) cut the repo rate by 25 basis points to 6.5%.
One basis point is one hundredth of a percentage. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the short and medium term interest rates in the economy.
In the column dated March 30, 2016, I had said that it is best if the RBI cuts the repo rate 25 basis points at a time and not more.
My logic for writing this was fairly straightforward. From January 2015 onwards, the RBI had cut the repo rate by 125 basis points. In comparison, the banks had cut their lending rates by only around 60 basis points. Meanwhile, they have cut the interest rates on their fixed deposits by more than 100 basis points.
This means that the banks have cut their lending rates at a very slow pace. Hence, there was no point in the RBI cutting the repo rate by more than 25 basis points, given that the banks have not passed on that cut to their prospective and current borrowers, in the form of lower lending rates.
In this scenario the best strategy for the RBI is to cut the repo rate 25 basis points at a time and then take a check if the cut has been passed on to the borrowers by banks.
And this is precisely what Rajan did yesterday by cutting the repo rate by 25 basis points. Honestly, the cut in the repo rate was not the most important part of yesterday’s monetary policy statement.
In the most important paragraph of the monetary policy, the RBI said that it will “continue to provide liquidity as required but progressively lower the average ex ante liquidity deficit in the system from one per cent of NDTL [net demand and time liabilities] to a position closer to neutrality.”
What does this mean in simple English? There is a certain demand for money that the banking system has. But there is only a certain supply of it going around which is not enough to fulfil demand. The difference is referred to as liquidity deficit.
Hence, banks cannot borrow as much as they want to from the banking system. In this scenario they have to pay a higher rate of interest to borrow.
The monetary policy statement of the RBI puts the liquidity deficit at 1% of demand and time liabilities. This means that the liquidity deficit in the banking system is at 1% of the total current account deposits, savings account deposits and fixed deposits, of banks.
As on March 18, 2016, the total demand and time deposits of banks stood at Rs 93,786,60 crore. The liquidity deficit is 1% of this and hence works out to around Rs 93,786 crore. This is where theoretically the deficit in the banking system should have been.
But the actual deficit is more than this. Rajan in his interaction with the media after presenting the monetary policy conceded that the actual liquidity deficit was around Rs 50,000-60,000 crore more than the RBI had estimated. This means that the actual daily liquidity deficit is around Rs 1,50,000 crore.
There are multiple reason for the same. Assembly elections are currently on in several states. Around this time, the cash in hands of the public increases. As Rajan said: “you can guess as to reasons why…we also guess.” This increase is not only in the states that go to elections but also in neighbouring states.
Then there was the issuance of tax-free bonds. Further, before the interest rates on small saving schemes were cut there was an inflow of money into these schemes. All these factors have essentially ensured that the liquidity deficit in the banking system is around Rs 1,50,000 crore.
The RBI now plans to bring down this deficit to a position closer to neutrality. The RBI plans to steadily reduce this deficit. The question is how will the RBI do this? The central bank will have to buy assets from banks.
One way of going about it is to carry out open market operations and buy bonds from banks. In fact, the RBI announced an open market operation of Rs 15,000 crore, yesterday.
The question is where will the RBI get this money from? The RBI, like any other central bank, has the ability to create money out of thin air by printing it, or rather by creating it digitally these days.
And this is precisely what the RBI will do—it will print money to buy bonds. When it buys bonds, it will pay for it through this freshly created money. When this freshly created money enters the banking system, the supply of money will go up and the liquidity deficit will come down. This will push down interest rates and in the process banks will pass on lower interest rates to the end consumers.
Of course this is not going to happen overnight and will happen over the course of this financial year and perhaps even the next.
In fact, what the RBI is trying to do is similar to what happened in the aftermath of the financial crisis that started in September 2008. The Federal Reserve of the United States decided to print money and buy bonds, in order to drive down interest rates, so that people would borrow and spend more. This is referred to as quantitative easing or QE.
The RBI is also doing a smaller version of QE. We can perhaps call it QE lite.
There were other moves also to help banks lower lending interest rates. Up until the RBI had maintained a difference of 100 basis points between the reverse repo rate and the repo rate.
While repo rate is the rate at which the RBI lends to banks, the reverse repo rate is the rate at which the RBI borrows from banks. Before today, the repo rate was at 6.75% and the reverse repo rate was at 5.75%. The difference, as mentioned earlier, was 100 basis points.
The RBI cut the repo rate by 25 basis points to 6.5%. At the same time, it increased the reverse repo by 25 basis points to 6%, thus narrowing the difference to 50 basis points. Hence, banks will now pay a lower interest when they borrow from the RBI and get a higher interest when they have excess funds, which they can park at the RBI. This basically will help banks to earn more and make it more likely for them to cut their lending rates.
Further, banks need to maintain 4% of their demand and time deposits with the RBI as a cash reserve ratio(CRR). Currently, the banks need to maintain 95% of the required CRR with banks on a daily basis. This has been lowered to 90%. This will help ease the pressure on banks and they will have more free cash. This should again help them cut their lending rates.
Up until now, the RBI repo rate cuts led to interest rate on deposits being cut more rapidly than lending rates. This time around, the lending rates are also likely to be cut.
Watch this space!
The column was originally published on Vivek Kaul’s Diary on April 6, 2016