RBI Announces a Cut in the Cash Reserve Ratio (CRR)
The Reserve Bank of India announced a cut in its cash reserve ratio of 50bp to 5.5%; it left policy interest rates unchanged. The policy statement indicated that the cut in CRR was needed to address the high level of deficit in the inter-bank liquidity. The policy measure was a positive surprise for the market. According to Bloomberg, out of 21 economists, five were expecting a CRR cut. We were assigning a probability of close to 50% for a CRR cut of 50bp. The CRR is the percentage of net demand and time liabilities (largely bank deposits) that commercial banks need to keep with the RBI as cash.
CRR Cut Will Help Reduce Inter-Bank Liquidity Stress
The cut in CRR will release Rs320 billion (US$6.5 billion) of liquidity into the banking system. We believe that this will help to reduce the persistent inter-bank liquidity deficit (net amount banks are drawing from the central bank). The RBI has already injected liquidity of US$14.4 billion via open market operations (buying government securities from banks) since November 2011, yet inter-bank liquidity conditions have remained tight. The slowing capital flows in the context of a current account deficit are adding to the stress. The net liquidity deficit in the banking system has increased to an average deficit of US$25 billion in January (until January 23), versus an average deficit of US$22.1billion in December and US$18 billion in November. The average deficits were US$10.3 billion in October and US$10.9 billion in September.
The RBI usually prefers to maintain inter-bank liquidity within +/-1% of net demand and time liabilities (NDTL), which amount to US$12 billion approximately. The liquidity deficit has significantly remained above its comfort range, especially since November 2011. The credit-deposit ratio still remains elevated at 74.9% for the fortnight ended December 30, 2011, even as credit growth during the same fortnight (at 15.9%Y) has slipped below deposit growth (at 16.9%Y).
The CRR cut should help to reduce the inter-bank liquidity stress, but we do not expect any lending rate cuts on account of the CRR cut, as the loan-deposit ratio still remains high at 74.9%. Typically, banks have approached the RBI for inter-bank deficit funding (at repo rate) when the loan-deposit ratio is above 72%. Hence, they are unlikely to resort to deposit rate cuts until April-May. For a decline in the loan-deposit ratio below 72%, we believe that credit demand growth needs to decelerate further from the current low levels of 16%.
RBI Still Concerned about Upside Risks to Inflation
Prior to the monetary policy announcement, RBI officials had been indicating in media interviews that to address the inter-bank liquidity issue, they prefer open market operations (OMOs) instead of cutting CRR. In the past, the RBI’s action on CRR has been perceived to be synonymous with a change in policy stance and its comfort regarding the inflation outlook.
In other words, does the January 24 CRR cut imply that the RBI is getting more comfortable with the inflation outlook? The monetary policy statement has clarified that the move to cut the CRR is to address the inter-bank liquidity deficit and that the RBI is still not comfortable with the inflation outlook. Indeed, the pre-monetary review released yesterday also indicates that the RBI is concerned about the upside risks to inflation.
While maintaining its inflation forecast of 7% by March 2012, the RBI has highlighted its concerns about upside risks to inflation. The policy statement has indicated five key forces: 1) potential increase in administered prices of coal, oil and electricity; 2) higher international crude oil prices; 3) recent depreciation of the rupee; 4) high government spending (and deficit); and 5) structurally higher protein-related food items (in this context, the policy statement also makes note of the lower area under coverage taken up by farmers for pulses).
Moreover, the RBI is concerned about the high level of non-food manufactured inflation. In December, non-food manufactured inflation rate remained high at 7.7%Y. In addition, the recent rebound in non-food manufactured inflation on a sequential basis has been a concern for the RBI. The three-month moving average of SA non-food manufactured inflation has moved up to 0.7%M (annualised rate of 8.4%) in December from 0.4%M in September.
RBI Cuts F2012 GDP Growth Outlook to 7%Y – in Line with Consensus
In the policy statement, the RBI indicated that downside risks to growth are materialising. These risks include “increase in global uncertainty, weak industrial growth, slowdown in investment activity and deceleration in the resource flow to the commercial sector. Consequently, while agricultural prospects look buoyant, industrial production has decelerated. The slowdown in industrial production will also impact service sector growth. Further, weaker global growth will also have an adverse impact. Accordingly, the baseline projection of GDP growth for 2011-12 is revised downwards from 7.6 per cent to 7.0 per cent.”
Emphasising the importance of policy action, it further stated “It must be emphasised that investment activity has slowed down significantly. As indicated, while global factors are contributing, domestic conditions are also responsible and a change in the investment climate is contingent on these adverse conditions being addressed by policy actions. Without this, a continuing decline in investment will push the economy’s trend rate of growth down, further aggravating inflationary pressures and threatening external and internal stability.”
Our views are very similar to those mentioned in the policy statement. We expect GDP growth to be 7% in March 2012.
When Will the RBI Cut Policy Rates?
In the context of the inflation outlook, one of the key factors identified by the monetary policy is the government’s effort on fiscal consolidation. The policy statement highlights:
“It must be emphasised that the timing and magnitude of future rate actions is contingent on a number of factors. Policy and administrative actions, which induce investment that will help alleviate supply constraints in food and infrastructure, are critical. Initiatives to narrow skill mismatches in labour markets will help ease the pressure on wages. The anticipated fiscal slippage, which is caused largely by high levels of consumption spending by the government, poses a significant threat to both inflation management and, more broadly, to macroeconomic stability.
Strong signs of fiscal consolidation, which will shift the balance of aggregate demand from public to private and from consumption to capital formation, are critical to create the space for lowering the policy rate without the imminent risk of resurgent inflation. In the absence of credible fiscal consolidation, the Reserve Bank will be constrained from lowering the policy rate in response to decelerating private consumption and investment spending. The forthcoming Union Budget must exploit the opportunity to begin this process in a credible and sustainable way.”
With the annual budget likely to be presented in March this year, we believe that policy rate cuts are more likely to follow the annual budget in March or later in April. We expect the RBI to cut policy rates by 100bp in 2012.
How Critical Is the Policy Rate Cut for Growth Recovery?
We believe that this is a very different cycle – currently, for recovery of growth, the investment cycle is key: Any measures that aim to push consumption would mean that inflation would remain higher for longer and increase the risk of a hard landing in the economy. Hence, the government needs to push private investment to revive growth this time, in our view.
However, a 100bp cut in policy rates is unlikely to be a sufficient trigger for revival in investment. Reviving the investment trend in a counter-cyclical manner will be tough. The already high starting point of the fiscal deficit – 9% of GDP – implies very little room for the government to pursue expansionary fiscal policy to boost public investment. As domestic demand growth decelerates further, thus reducing inflation pressures, there could be some room for moderate cuts in policy rates. However, we believe that an interest rate cut is unlikely to be sufficient to kick-start the investment cycle. Indeed, private investment has slowed even though real interest rates remain negative. As inflation moderates, real interest rates will need to be high for some time to ensure that we lift savings enough to fund the eventual rise in investment. Since the investment cycle typically has a longer gestation period, we believe that policy-makers must move quickly to reduce the possibility of a vicious cycle.
Two Key Triggers for Recovery in Growth
Two key factors can help support investment and therefore GDP growth recovery:
(a) Global capital markets: Global capital markets weigh on capital inflows into India and also tend to influence the risk appetite in the domestic markets. This is particularly important for India because its corporate sector’s investment funding depends more on capital markets than bank credit. Moreover, many companies’ businesses are now linked to the global economy; thus, their investment decisions depend on the global economic outlook. Since the developed world is facing major structural challenges, support from the global economy and capital markets may not be forthcoming. Hence, to support investment growth, the government needs to focus on policy reforms to get the productive dynamic back, in our view.
(b) Government policy action: If global support is less forthcoming, we believe that the only way to revive investment would be a ‘campaign-style’ effort from the government, which should include major policy reforms and a focused approach to speed up its execution machinery. For a detailed discussion, see our chartbook (Next Debate: Duration of Growth Slowdown, January 9, 2012).