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The RBI began its first phase of exit from an expansionary policy by ending some liquidity support measures

Contributed by Nirmal Bang

By Nirmal Bang

The Reserve Bank of India (RBI) has explicitly signalled a mild exit strategy from the loose monetary regime, indicating the beginning of the end of the stimulus measures.

‘Unconventional times require unconventional measures’ was the underlying thought of the RBI when the post-Lehman crisis came knocking at India’s economic doorsteps. To tackle the crisis, the RBI had then opened multiple floodgates to liquidity.

However, in the recent monetary policy review, while the RBI decided to keep all its key policy rates unchanged, it did embark on a passive exit strategy by discontinuing few emergency liquidity facilities and revising provisioning norms that were undertaken last year as crisisfighting measures.

So, while the Repo (rate at which banks borrow from the RBI against government securities) stays at 4.75%, the reverse-repo (rate at which banks parks their surplus liquidity with RBI) remains 3.25% and Cash Reserve Ratio (percentage of banks’ net demand and time liabilities parked with the RBI in cash and cash equivalents) stays at 5%, there are some tweakings from the policy.

These include: reduction of export credit finance limit to 15% from 50%, discontinuation of special refinance facility for banks, discontinuation of special term repo facility for mutual funds, discontinuation of forex swap facility given to banks and phasing out of special liquidity facility for NBFCs after 31st Dec ’09. “The withdrawal of these unconventional measures is unlikely to make any material difference as very few entities have availed of such special liquidity facilities off late,” says a Deutsche Bank report.

With around Rs 1,20,000 crore of excess liquidity already sloshing around in the system, RBI’s move should be looked upon as more of a signaling device of further liquidity tightening measures that are likely to follow in the days ahead, the report adds. Several people support this view.

“Given the current level of systemic liquidity and the revival of debt and equity capital markets, the economy should be able to absorb these changes” says Chanda Kochhar, Managing Director and CEO of ICICI Bank, in her comments on the policy.

Among the critical signaling tools, RBI did announce a 1% hike in the Statutory Liquidity Ratio (SLR), the proportion of deposits invested in government paper, from 24% to 25% of net demand and time liabilities. Last year, at the height of the global financial crisis, the RBI had lowered the SLR to 24% as a liquidity easing measure. “Given that currently banks are maintaining a SLR of 28%, this announcement is unlikely to have any material impact on interest rates in the short term,” says a leading economist.

On a standalone basis, the increase in SLR ratio should create a demand of about Rs 44,000 crore of government bonds and a similar decline in the funds parked with the RBI. “However, this move appears more of an insurance against the possibility of the government borrowing suffering, in case there is an increase in demand for funds by corporates,” he adds.

The rationale behind the SLR hike by the RBI might seem a little difficult to fathom but is eminently sensible, says Abheek Barua, Chief Economist, HDFC Bank. Barua explains that the problem in the money and debt markets at this stage involves the private sector’s limited appetite for funds, because growth in the sector is still somewhat patchy.

On the other hand, the government is playing a critical role in driving the economy forward through its countercyclical measures. As a result its appetite for funds is extremely high and yet, the market seems a trifle unwilling to lend to the government. This has resulted in a somewhat ironic situation where liquidity is abundant on the back of a super-accommodative monetary policy but government bond yields keep moving up.

The SLR hike solves this problem – it allocates more liquidity to government, puts a lid on G-Sec yields and helps fund the counter-cyclical policy at a lower cost. “For those concerned about inflation, the SLR increase has a monetary policy dimension as well – it sterilizes some of the excess liquidity in the banking system,” says HDFC Bank’s Barua.

Inflation is a monster in the rising once again. Double-digit inflation rate is not distant history as yet and now there are concerns that inflation rising. Inflation based on the Wholesale Price Index (WPI), moved into the positive territory in September after staying in the negative zone for 13 weeks.

The current rise in inflation is mainly due to the sharp increase in food prices resulting from deficient monsoon and hence lower kharif production. Even the tone of the monetary policy has been hawkish, with clear indications that rising inflation expectation is turning out to be a bigger concern for the RBI now than growth.

One must note that the policy has moved away from ‘managing the crisis to managing the recovery’. The RBI continued to put weight on economic growth considerations but shifted its focus somewhat to inflation, revising inflation forecast to 6.5% with an upward bias from the earlier 5% expectation.

In its review, the RBI decreased its projection of credit growth to 18% from 20% for fiscal ending March ’10. Economists expect that the target of 18% is achievable, given India's robust economic momentum. Credit growth is still strong in the industrial sector, led by infrastructure, where it increased 12.24% between March and August this year.

From the banking sector perspective, the policy stipulates that banks maintain a minimum provisioning coverage of 70% on their non-performing assets (NPAs) by end-September ’10. This is a measure aimed at strengthening the Indian banking sector in the long run.

Rating agency Crisil believes that the measure will enhance the resilience of the banking system to absorb loan losses. However, the measure will also lead to a decline in the sector’s profitability over the near term. The banks’ NPA reporting as on 31st Mar ’09 stood at 2.3% of system advances, while the NPA coverage was around 55%. On the basis of these reportings, the rating agency estimates that the proposed norm will mean that the banks now have to make an additional provision of Rs 13,000 crore till end-September ’10. In April ’09, Crisil had forecasted a sharp increase in NPAs from 2.3% to 3.9%.

However, due to extensive restructuring, thanks to RBI’s unconventional measures, NPAs are unlikely to increase to the extent that Crisil had previously expected them to. However, even if NPAs rise to 3% by March ’10, the required additional provisioning will increase by Rs 20,000 crore. In that case, the total provisioning requirement for the system could shoot up to Rs 30,000 to Rs 33,000 crore by end-September ’10.

“The expected increase in provisioning will aggravate the profitability pressures that India’s banks have been facing on account of pressure on fee income,” explains Raman Uberoi, Senior Director, Crisil Ratings in its latest release. The additional provisioning will be approximately 20% to 25% of the sector’s expected profits for 2009-10 and 2010-11, as the impact will be spread over two years.

The impact on the profitability of individual banks will however, vary depending on the age of its NPAs, the available security and its internal policy. For the 35 Crisil-rated private and public sector banks, it ranges from 30% to 90%.

Eight banks meet the minimum threshold of provisioning coverage already; another 16 have provisioning coverage ranging from 50% to 70%, while the remaining 11 banks have coverage of less than 50%. The impact of the provisioning on profitability may be higher for these 11 banks, the release adds further.

With regards to the policy impact on interest rates, the pressure on the benchmark 10-year paper should decline going forward, as the supply of government securities will come down significantly in the second half of the year. “The disinvestment strategy of the government is likely to attract more foreign investment and hence increase liquidity in the system,” says a research note from Crisil Research.

Around the world there is an active debate on the timing and sequencing of exit from the expansionary monetary stance. “Exit is a central issue in our policy matrix too,” asserted D Subbarao, Governor, Reserve Bank of India, in his statement.

The challenge for the Reserve Bank is to support the recovery process without compromising on price stability. “Growth drivers warrant a delayed exit, while inflation concerns call for an early exit,” Subbarao added. He is of the opinion that premature exit will derail the fragile growth but a delayed exit can potentially endanger inflation expectations.

The Reserve Bank fought the crisis in a calibrated manner using one or more weapons at a time as the situation called for. The unwinding would also be a slow synchronized process, but the policy review has lifted the curtains of this process. More shall follow soon.