What confusions a 0.25 rate increase can cause
Posted by g.e. on November 19, 2006
(Setting: YVR’s late October repurchase rate hike)
Last week, the Reserve Bank of India raised, by a quarter point, the repurchase rate it charges banks for lending them overnight funds, while leaving unchanged the reverse repurchase rate it pays them for temporarily taking over their excess cash.
The central bank says it will charge more for lending money even though no one is borrowing from it. At the same time, the monetary authority has refrained from raising the rate at which it is draining billions of rupees in surplus cash every day. That is perplexing.he decision is doubly surprising because it is the latter rate – the one that has been left unchanged – that is considered to be the central bank’s benchmark.
The two indicators have been used since early 2004 to create a corridor for short-term money-market interest rates in India. The reverse repurchase rate sets the lower limit of the range; the repurchase yield acts as the ceiling.
Since the banking system has usually been in a surplus- cash mode, the floor has come to be acknowledged as the policy rate. That notion came crashing down last week. The symmetry of interest-rate action, which the market had taken for granted over the past year of synchronous increases in the repurchase and reverse repurchase rates, was broken.
As long as banks do not have to borrow from the central bank, the rate increase would have little effect.
The Reserve Bank of India estimates that the banking system currently has an average “liquidity overhang” of 852 billion rupees, or $19 billion, lower than 924 billion rupees from July to September.
If the excess cash in the system does dry up, as it did at the beginning of this year, the Reserve Bank will become a supplier of liquidity of last resort.
Only then will the increase last week in the cost of funds – to 7.25 percent, from 7 percent – start to bite. Until then, the benchmark is the floor rate, left unchanged at 6 percent.
So in effect, the Reserve Bank of India governor, Y.V. Reddy, is telling banks to brace for a cash crunch. To escape it, they must contain runaway credit growth by raising the price they charge consumers for home and auto loans.
If that is indeed the strategy, then it also means the Reserve Bank would not be too eager to buy dollars to stem the appreciation in the rupee, which has risen almost 5 percent against the dollar since July 19.
By buying dollars, the monetary authority would bolster local money supply. Unless it scoops out the funds by selling bonds, banks would have even more surplus cash than at present.
Three years ago, a panel established by the Reserve Bank had anticipated the confusion that would arise from using the reverse repurchase rate for mopping up excess liquidity as well as signaling the stance of monetary policy.
Using the reverse repurchase rate to indicate higher borrowing costs in the economy automatically increases the cost that the central bank incurs when selling bonds to contain money supply. And that compromises the efficacy of the benchmark.
The policy rate must be in the middle of the interest-rate corridor, not at its bottom, the committee had said.
The concerns expressed by the panel have suddenly become very real. The bond market and the central bank both need an uncompromised benchmark.
And, from the BS roundtable:
OP Bhatt, chairman, State Bank of India, said the current rate of credit growth was not sustainable for the fourth year in a row and liquidity in the banking system was meant for sectors like exports, infrastructure and capital expenditure in the manufacturing sector. “The policy says if you have money, lend. If you come to me, liquidity will be expensive,” Bhatt said, but stressed “at the moment, rates will not be raised”.
KV Kamath, MD and CEO, ICICI Bank, also said rates would remain stable for the time being and there was no signal from the market on rates going up. “Interest rates will remain stable for the time being,” he said.
Naina Lal Kidwai, country head (India), HSBC, said the bank was following a wait and watch policy over the next quarter. Credit offtake, liquidity and inflation will be the deciding factors.