Cuts without conviction

Illustration: Sudeep Chaudhuri

BY PANDERING to political whims and market pressures, the Reserve Bank of India’s (RBI) decision to cut rates and ease liquidity is premature, and will make it difficult to support growth later in the year.

In the cacophony to cut policy rates, RBI has reduced the benchmark interest rate by 25 percent. To ensure that it is seen as a “please-all” policy, RBI Governor D Subbarao has thrown in a 25 basis point cut in the cash reserve ratio (CRR). This will help commercial banks to borrow from RBI at a lower cost before they are able to pass on the benefit of lower interest rates to consumers.

The idea, noble as it may sound, is unlikely to turn the economy around. For one, since 1990, lower interest rates have not led to high growth simply because of increased borrowings. By reducing rates and making more money available through a policy signal, the RBI has compromised the integrity of the Annual Monetary and Credit Policy. In its pre-policy review of the economy, the central bank gave every single reason — from current account deficit to fiscal deficit to global uncertainty — for not cutting rates. Yet, within 24 hours, it ignored its own analysis and cut the repo rate by 25 basis points. It would appear that the RBI first outlined what it should do, and in the policy, it has done what it was asked to do!

The 25 basis point reduction in the repo rate can be understood — if not justified — in light of the “guidance” (read commitment) that the RBI had given in its policy review. Also, a marginal reduction is not going to have a major impact, either way. What is incomprehensible is combining the repo rate cut along with a cut in the CRR, which will inject around Rs 18,000 crore of primary liquidity into the system. What was the need to do this when there’s enough money in the system? In any case, for the next two months, inflows are expected and liquidity would have remained sufficient.

More importantly, by cutting CRR, the RBI has restricted its own policy flexibility. By cutting only the rate and not the CRR, it could have used liquidity management, open market operations, and gone either way, depending on the emerging situation in these uncertain times. By cutting CRR along with the repo rate, the RBI may have just overplayed its cards.

If, in the next six months, the macro economy gets worse, there may have to be a rollback and rates may have to be increased, which would be a policy disaster for the central bank. The policy has also failed to reflect in detail on emerging stress in the banking sector, especially the deteriorating quality of loans. According to the RBI’s own numbers, growth in non-performing assets (NPA) has exceeded the rate of growth. Over the past year or so, the NPA growth on a year on year basis has consistently outpaced the growth in advances.

In its financial stability reports, the RBI has detailed out the extent, spread and trajectory of the incipient banking crisis, which is only a notch away from alarming. Why is this credit policy content with making only one macro comment on this key issue?

An analysis of the earning quality shows a serious and growing disconnect between the reported earnings and underlying earnings of banks. The balance sheets of all banks in 2012 are weaker than in 2008. The banking sector as a whole today is less profitable, less stable, less sound and with poorer asset quality as compared to 2008 and the recent past. All these facts seen in the context of a slow growth, a depreciating rupee, fiscal imbalance and the global sovereign debt crisis should have alerted the RBI to focus on tightening prudential norms.

It is time the RBI reminds itself that it is not only a monetary authority whose objective is maintaining price stability and ensuring adequate flow of credit, but also a regulator and supervisor of the financial system. Had the RBI chosen to follow an easier monetary policy over the past several quarters, it would have ensured better utilisation of credit along with greater strength to face deterioration in asset quality. That it hasn’t done so will cost the economy very dear.


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