Tuesday, March 10, 2009

RBI Slashes Rates

The Reserve Bank of India (RBI) has recently slashed Repo Rate-- the rate at which it lends money to banks for short terms — and the Reverse Repo Rate — the rate at which it borrows funds from banks--as part of efforts to moderate the cost of borrowing by a slowing economy. The RBI reduced the Repo Rate by 50 basis points from 5.5 per cent to 5.0 per cent. The apex bank also reduced the Reverse Repo Rate by 50 basis points from 4.0 per cent to 3.5 per cent. The new changes came into effect immediately. The Cash Reserve Ratio (CRR) has not been tinkered with because the liquidity situation remains relatively comfortable.

The RBI admitted that concerns over rising credit risk together with the slowing of economic activity appeared to have moderated credit growth despite reduction in lending rates by private and public banks. It further warned the banks to guard against rising non-performing assets.

The RBI continues to urge the banks to monitor their loan portfolio and take early action, to prevent asset impairment down the road and safeguard the gains of the last several years in improving asset quality. At the same time, the RBI stated that the banks should price risk appropriately and ensure that creditworthy enterprises continue to get funding. The RBI noted that it had pumped in more than Rs 3,88,000 crore into the economy through various measures. This sizeable easing has ensured a comfortable liquidity position. The overnight money market rate has remained near or below the lower bound of the LAF corridor since November 3, 2008.

Impact of Reduction
As a result of these cuts, loans for buying houses, cars, two-wheelers and white goods are expected to become cheaper in April as banks have indicated that they may reduce interest rates by then. In the US, Europe and several countries interest rates have been slashed sharply, even to zero per cent, to encourage consumers to spend their money instead of keeping it in banks. In India, however, interest rates cannot fall to those levels because the RBI keeps the bank deposit rates high to encourage savings and help pensioners surviving on interest income.
State-owned banks are lending to their prime customers at around 12 per cent and private banks charge up to four percentage points more, not significantly less than a year ago. Partly because banks donot seem able to shake off their aversion to risk and partly because the Government’s humungous borrowing programme is overwhelming the money market.

Of the Rs 390,000 crore the RBI has pushed into the system since the global credit market seized up, the Government will have moped up Rs 326,512 crore in the year to March 2009. In 2010, the Government intends to borrow another Rs 332,835 crore. Add to this the leeway States have been given to borrow in excess of their medium-term targets. Financing the Centre’s fiscal deficit — optimistically projected at 5.5 per cent of the Gross Domestic Product (GDP) — is crowding out lending to other sections of the economy, explaining the downward stickiness of interest rate.

Tough Options
The apex bank’s decision to lower the Repo and Reverse Repo Rates comes at a time when monetary policy is facing tough options in combating the economic slowdown and the depreciation of the rupee simultaneously. With this, the central bank has reduced these rates as many as five times since September 2008. On all the previous occasions, monetary easing was its overwhelming objective, and for obvious reasons. This time too there is a signal to banks to lower their rates but there are two other developments that have made the choice not as clear cut as earlier.

With the Government running out of fiscal options, the RBI’s role in stimulating the economy has become more pronounced. The rupee has dropped from 49 to the dollar to just below 52 in a matter of two weeks. On March 3, 2009, it closed at its lowest level in more than three years as investors continued to flee the Indian stock markets. In normal times, a hike in interest rates, rather than a reduction, would have been one of the correctives to such a sharp depreciation.

Prevailing Uncertainty
The latest cuts impact with a time lag. Therefore, we need forward-looking instead of reactive monetary policy, which factors in falling inflation, demand and output and creates a pre-emptive countervailing force. India is gearing up for the G-20 Summit to be held in April 2009 where it will seek to synchronise its growth-boosting efforts with the rest of the world.

In reviving economic growth, banks play a major role. The RBI controls money supply in the system through its key rates. If there is too much money and inflation goes up, the RBI tends to squeeze liquidity. Now that inflation is quite low at 3.03 per cent, the RBI is releasing more money in the system. Since September 2008 the RBI has slashed its key rates frequently and injected Rs. 1,60,000 crore more in the system.
The present cuts should be seen in this context. At the moment, there is a great deal of uncertainty whether the packages will work as anticipated, and also about the inflationary potential they have built up for the medium-term. The aim is to spur consumer demand and stimulate the economy.

No comments: