With the US Federal Reserve cutting the Fed rate by 75 bps and holding out the possibility of more cuts at its regular meeting on January 30, this means accelerated inflows to India (the interest rate differential between the US and India is now 425 bps) and a higher probability of a further hike in its Cash Reserve Ratio. Since March 2006, the RBI has raised CRR by a huge 250 bps. On an average, this has pushed up the cost of funds for the banking system by 100 bps.
The accelerated inflows of capital (between mid-November 2006 and now, FII inflows were a whopping $21.9bn) have driven up the rupee and to stem this, the RBI's net dollar purchases between end-March 2006 through November 2007 were as high as $55.2bn. The liquidity thus created is then sucked out by using various tools like the CRR, issue of market stabilisation bonds, liquidity adjustment facility operations and so on.
The RBI has tried to distribute the burden of excess capital inflows equitably across all interest groups. By curbing ECB inflows, a part of the burden is transferred to the corporate sector; by increasing the MSS ceiling to Rs 2.5 trillion, a part of the burden is transferred to the government (in 2007-08, MSS will cost Rs 8,200 crore); by removing the cap on daily liquidity absorption through the reverse repo window, a part of the burden is shouldered by the RBI itself; and by raising the CRR steadily, a part of the burden is transferred to the banking industry.
With inflows now certain to rise, the MSS supply to money market has already started increasing. On January 11, the RBI announced two auctions, notably, Rs 4,000 crore (Rs 40 billion) of 11.3 per cent 2010 bond and Rs 5,000 crore (Rs 50 billion) of T-Bills under the MSS. While the current outstanding under MSS is at Rs 1.56 trillion, the ceiling is at Rs 2.56 trillion. As the RBI has been using all instruments at its disposal to control liquidity in a flexible manner, it is quite likely that it will again raise the CRR in the near future to maintain appropriate liquidity in the system.
How effective is the policy of increasing reserve requirements in dealing with large capital inflows? First, as long as domestic reserves do not pay a competitive interest rate, reserve requirements are a tax on the banking system. In general, we expect two kinds of responses from banks to changes in reserve requirements. Depending upon the market power, the banks would either pass on the reserve tax to depositors (by lowering interest rates on deposits) or to borrowers (by charging higher interest rates on loans). However, in either case, a downward pressure will be exerted on the value of the home currency in the foreign exchange market.
The Indian banking system, however, presents a case of distorted responses. In the year 2007-08, though the banking industry's deposit growth (at 13.2 per cent over March 2006) has been in excess of the credit growth (11.4 per cent), the deposit rates have more or less remained sticky downwards. In fact, some banks have increased deposit rates in the recent past.
A relatively higher share of low-cost deposits (especially for state-owned banks) and tremendous pressure to build up the balance sheet (due to a lingering fear of the onslaught of consolidation) primarily explain the sticky nature of deposit rates, despite a hike of 175 bps in the CRR since March 2007.
From the assets' side, the burden of "reserve tax" has primarily fallen on small and medium enterprises, as they are heavily dependent on bank finance. Large corporates with strong financial muscle (with sufficient backing of internally generated funds), however, manage to get loans at highly competitive rates leaving banks with thinner margins.
Moreover, in the Indian context, there is a limited scope for banks to price their loans competitively across all sectors due to a plethora of regulatory prescriptions such as those for loans up to Rs 2 lakh (Rs 200 million), production loans for farmers up to Rs 3 lakh (Rs 300 million), concessional finance for exporters and sectors under stress like sugar, tea, coffee, marine products and so on.
Furthermore, the RBI has stopped paying any remuneration to banks (from April 2007) on CRR balances, which entails a substantial loss to the banking industry (estimated at around Rs 4,600 crore).
It will be interesting at this stage to look at the international experience regarding remuneration on reserve requirements. According to a Paper entitled "Reserve Requirement Systems in OECD Countries" by Federal Reserve Board, Washington DC (2007), the "remuneration" in most OECD countries is based on holdings of reserve balances up to the required amounts and is paid at a rate below overnight market rates. The paper, however, says most countries remunerate banks for their holdings of required reserve balances. But "excess reserves" are normally not remunerated, or, are remunerated only on a limited portion or at a reduced rate.
Given the ongoing rally in Indian stock markets and continued robust inflows of foreign capital, the risks of further hikes in the CRR and more losses on "remuneration" have increased considerably for the Indian banking industry.
The implications of this trend are more damaging to the real sector, as the "burden of reserve tax" will increasingly be borne by the SMEs - the future growth driver of Indian economy. Also, there will be lesser incentives for policymakers to deregulate the saving bank deposit rates, which are helping banks a great deal in absorbing the "shock" of reserve taxation.
As an interim step, the RBI may like to review the matter with respect to payment of interest on CRR balances and to impose the CRR on incremental deposits rather than on total net demand and time liabilities in the forthcoming review of the monetary policy.
However, the real "solution" worth considering would be the strategy adopted by Chile in 1991, where "reserve requirements" were imposed on all capital inflows for a short time period (that is, a per cent of inflows were deposited with the central bank, with no yields or returns to the investors). The "reserve requirements" then were changed depending upon the amount of flows.
This kind of "intervention" from the government may be justified to correct the present "distortions" in the Indian economy and also to accomplish a goal of more balanced growth. Otherwise, the situation of "rob Peter to pay Paul" would continue indefinitely.
The author is Chief Economist, Bank of Baroda and can be reached at chief.economist@bankofbaroda.com
