By Sourajit Aiyer
The Indian central bank’s upcoming policy review this week, a month after demonetization, holds ample suspense for a possible interest rate cut.
The demonetization of Rs 500/1,000 currency notes since November 8 has led to a rapid inflow of deposits in banks. Brought in to fight black market money and counterfeits, the amount in circulation in these notes was estimated at around Rs 14 trillion, i.e. about 86% of the total.
Citizens were asked to deposit them in their banks, leading to the deposit surge. The Hindu, a leading daily, said ~Rs 8.5 trillion had been deposited by end November and estimated it to reach between Rs 10-11 trillion by early-December.
On top of this, the few days prior to this announcement had also seen a surge in deposits of around Rs 2.9 trillion. This was believed to be mainly on account of arrears received of the seventh Pay Commission, additional savings made due to the Indian festival season and the recent income declaration scheme.
So why does the upcoming policy review hold suspense for a possible rate cut? As India’s millions lined up to deposit their notes, liquidity in the system expanded. The issue was, where to deploy this? Given the reaction of market indicators after this, the central bank’s follow-up actions, and the state of the economy itself which needs a booster, the scenario on interest rates in the upcoming review remains unclear due to two contrary issues.
Issue #1: Indian banks are required to park 4% of deposits with the central bank as cash reserve ratio (CRR), and another 21% to buy government bonds as statutory liquidity ratio (SLR). Following the increased liquidity, the demand for bonds leapt up, and this hit bond yields.
The yield on the 10-Year government bond fell from about 6.8% to 6.2% between November 8 and end November. The yield on the one-year government bond fell from about 6.5% to 6.0% in the same period, to the extent it fell below the repo rate, the policy rate at which the central bank lends to banks.
At the same time, bond yields in the US were moving up following the US elections. As the differential between Indian and US bond yields narrowed, the worry was a flight of capital. As per CDSL data, the month of November saw ~Rs 211 billion net outflows by FPI/FII from Indian debt. Indian bond yields needed to be pushed back to attractive levels.
In the last week of November, the central bank announced that 100% of deposit inflows received from Sep 16 to Nov 11, about Rs 3.2 trillion, would need to be kept with the central bank as CRR. While this meant the banks effectively would neither earn from lending nor from bonds on this, it reduced the surge in demand for bonds.
This helped bond yields and prices to stabilize at the month’s end. This was needed not only for attractiveness in yields, but also to safeguard banks from possible investment losses from buying high, since the yields would rise once the deposits were withdrawn eventually.
After all, much of these deposits would not be sticky. Due to the limits on daily withdrawals, people were not taking out the cash at the same pace. When the supply of new notes would stabilize, much of these would be withdrawn, and the resultant impact on bond prices was a concern.
Apart from buying bonds under SLR, the sluggish demand for credit had made banks deploy funds in the reverse-repo of the central bank, under which it buys further bonds at the reverse-repo rate of 5.75%. Resultantly, the existing supply of bonds with the central bank was nearing its limit. So the 100% CRR move was a quick way to dry some liquidity.
This was followed by other steps, like the revision of the limit of the market stabilization scheme limit to Rs 6 trillion from Rs 300 billion for 28-days. Under this, the central bank would issue cash-management bills to reduce some liquidity.
These indicate the central bank is perhaps placing priority to stabilize the markets and yields, and thus maintain India’s attractiveness relative to safer-havens like USA. This may hint that a rate cut, at least in the near-term, may not be in the anvil in case it impacts India’s relative attractiveness and leads to further flight of capital.
Moreover, due to the moves like 100% CRR for liquidity management, banks would now look to earn more from what they can lend out to make up for what they had to forgo. Thus, leaving rates unchanged would help protect their spreads.
Issue #2: Given the rapid supply of deposits in banks, their ability to lend more credit has enhanced. As these deposits were mainly lower-cost current account/savings accounts, they carry lower rates of interest, thus better spreads. A lowering of rates could create the incentive to avail credit, which could kick-start the economy.
Moreover, the formalization of the economy due to fewer cash transactions, less unaccounted monies and more digital monies would multiply the flow into banks, which was curtailed till now as most of the cash never found its way to the banks.
A further drop in interest rates would lower the yields eventually, thus benefiting those who bought bonds now. Lower yields also disincentives banks to hold bonds above the SLR limit, thus making more funds available for lending.
However, what has been good for liabilities may not be great for assets, in the case of banks. While the need to boost the economy with a booster like a rate-cut holds ground, the ability to give more credit presupposes there is demand for credit in the first place.
The sluggish economic growth since the UPA-II government’s era had hit credit demand. Rating agency CARE said India’s credit demand for the seven months till October grew a mere 0.8% YoY. As industrial output remained slow, the credit demand in this sector declined 4.6% YoY. Even services were not spared, and its credit demand grew only by 2.8%.
On top of this, demonetization has crunched immediate consumption, in a country where CLSA, the leading broker, estimates 68% of all transactions are cash-based. Business activity in the unorganized sector, where ILO estimates 85% of India’s labour-force participates, especially took a hit as the lack of cash hit working-capital cycles.
The worry is that credit off-take, already low, has taken a further short-term hit following demonetization. Retail and SME-related loan segments are expected to take the maximum brunt in the near term.
These indicate the central bank needs to prioritize reviving the economy, to push the consumption and investment cycle. This may hint that a rate cut may be on the cards, as it would help the economy get momentum in the medium to long term, despite any near-term crunch due to demonetization.
A cleaner economy would ideally also increase the interest of more foreign investors, and an initial revival in the economy would help that objective.
The case is strong for both for and against a rate cut in the upcoming policy review of India’s central bank. Given this backdrop, the analyst and investor community will be closely watching the meeting this time.