Finally, a credit policy worth writing about!

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July 27th, 2010 Rajiv Shastri

In Tuesday’s credit policy announcement the RBI hiked rates as expected. But for the first time in years, it hiked the reverse repo and repo rate unequally. This can only be good.

In times of surplus liquidity, the RBI borrows from the market at the reverse repo rate, the lower of the two policy rates. On the other hand, in a deficient liquidity scenario, it lends to the market at the repo rate. The difference between the two rates, which was 50 basis points (bps) at the time they evolved into policy rates was relentlessly widened to 150 bps during the governorship of Dr Y V Reddy.

The reasons behind this change were never explained fully, but then, Dr Reddy wasn’t inclined to explain most of his monetary policy actions. In use, however, this gap became a potent monetary weapon which could be wielded at any time to change rates dramatically without any apparent change in monetary policy. It gave the RBI power to change market conditions without changing policy rates and was used frequently, often with devastating effects.

The use of this weapon was considerably easy, using RBI’s almost complete control on systemic liquidity. Small changes in CRR can make the difference between a liquidity surplus and a liquidity deficient market. Moreover, with government tax collections being periodic and chunky, it is possible to turn a liquidity surplus system to a liquidity deficient one without an action. Since advance tax payments will be made as scheduled, by not taking any action to compensate market liquidity for such outflows, banks could move from lending to the RBI at the reverse repo rate to borrowing from the RBI at the repo rate.

Since such lending and borrowing operations decide the overnight rate, which is the foundation for the term structure of interest rates, it was possible for the RBI to change systemic interest rates by up to 150 bps without any monetary policy action. This allowed the RBI to conduct monetary policy in a covert manner, unbecoming of a government institution in a democracy. It also introduced uncertainty in the overnight rates, which resulted in higher spreads and consequently, higher rates for long term borrowers. How does one price a five-year loan/bond if one isn’t sure whether the overnight rate is 3.5% or 5.0%?

This first step in reducing the width of what is colloquially called the LAF “corridor” needs to be lauded despite the fact that this corridor is still too wide. More such steps will be needed which will, hopefully, reduce the gap to either 25 or 50 bps. This will stabilise overnight rates across liquidity conditions, stabilise overnight rate expectations and result in finer pricing for the term structure. Ultimately, it will lend more credibility to monetary policy actions by improving their transmission to the banking system and the real economy.

It’s easy to say that more could have been done, but to my mind, even if the credit policy statement consisted of just this one sentence, it would still be a good policy. Well begun is half done, the saying goes, and it’s apt in this context. At this time, we need to celebrate RBI’s tacit acknowledgement that this is a problem which needs to be corrected.

Another issue that needs to be addressed is the use of CRR as an instrument of monetary policy. Encouraged by China’s success in using CRR to manage system liquidity, recent statements by senior RBI officials show the inclination to use it here is rising. The width of the LAF corridor, no doubt, added to its attraction with one monetary tool influencing both liquidity and interest rates. However, considerable challenges exist in its use in India when compared to China. The banking system in China is characterised by its homogeneity in ownership and to a certain extent, size. In this environment, an increase in reserve requirements impacts all banks almost equally resulting in efficient transmission. This isn’t the case in India.

With banks of all size and ownership structures co-existing, changes in reserve requirements have an unequal impact which can result, and has historically resulted, in occasional existential problems for banks disadvantaged by such changes. And if this tool is used in place of, rather than along with other liquidity intervention methods, it can disrupt normal functioning of the banking system. This has been proved in the past, with October 2008 being the most extreme manifestation of its impact.

It is expected that a reduction in the width of the LAF corridor would reduce the attractiveness of using CRR as an all-in-one tool and result in distinct monetary tools being used for managing liquidity and interest rates. But this is merely an expectation. As in the case of narrowing the LAF corridor, we need to wait for evidence in either words or action.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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4 Responses to “Finally, a credit policy worth writing about!”

  1. Rajiv Shastri Says:

    Thank you for your kind words, Rahul

  2. Rahul Says:

    I was pleasantly surprised to see that your replied to my message. Thank you. I read through your blog, very informative. You just added another follower and a regular reader to your blog.

  3. Rajiv Shastri Says:

    @rahul, I guess I wasn’t clear enough in my post so will make an attempt to explain further.

    The CRR is a regulatory instrument and not a monetary policy instrument. While many developed nations have abolished the use of reserves completely, I believe that it is an important part of the regulatory environment. However, CRR is a cost for banks and different banks have different tolerances to frequent changes in the cost structures of their operating environment. Every industry deserves a stable regulatory environment and the banking industry is no different. So frequent changes in CRR are best avoided.

    If system liquidity is what the RBI wishes to change, it has other non-regulatory instruments it can use. It can use the market stabilization scheme (MSS), conduct open market operations or even use the foreign exchange market, if conditions permit. CRR is considered to be an attractive instrument because its believed to be cost free for the Government and the Central Bank. Some even consider it to be cost-free to the banking sector. A discussion on this can be found on my blog (www.rajivshastri.com) in the post titled “An Exchange Rate Policy for India”.

    As far as the liquidity impact of the Reverse Repo and Repo rate is concerned, there is none. These rates change only the cost of money, not the amount available.

    Using distinct instruments for managing liquidity and interest rates will impart greater transparency to monetary policy, enhance communication of intent and improve transmission.

  4. Rahul Says:

    The change in CRR is more appropriate when the govt. really wants to hold back the horses.
    Repo and Reverse Repo do not have a large enough affect on the liquidity, which makes sense at this point of time as we are also expecting average moonsoon and also need to balance the growth potential of the country with respect to china and other developed nations..

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