Interpreting the Pre-emptive move of RBI

Is inflation really a cause of worry? May be yes if the oil prices continue to rise. Reading articles on the RBI’s move to increase the reverse repo rate, I am confused. I will better rely on what theory says and try to interpret whether increasing rates make sense.

The issue of increasing the interest rates is related to demand and supply of money. Supply of money is to be understood with the liquidity aspect associated with it. What factors have driven the demand for money in the Indian economy? As per the RBI statistics the non-food credit adjusted for non-SLR investments recorded a year-on-year growth of 28.3% on Jan.06, 2006 as compared with 27.9% a year ago. The demand for credit increases when the firms are making investments in capacity expansion to meet the increased demand for products. As the demand for credit increases, theoretically speaking, the interest rates would rise. As the cost of funds for the commercial sector increases they would be prompted to delay their investment plans or explore other sources for meeting their demand for credit.

Before going further it is imperative to understand the various fund raising options the commercial sector has in India. The table below shows the select sources of funds to industry.

Source: Reserve Bank of India report

Observing the table the ratio of bank credit to non-bank credit has been 61% in Q2, 2005 compared to 41% in Q2, 2004. Funds raised from equity markets increased to Rs. 5,397 crores in Q3 from Rs.4,977 crores in Q2. The other sources for raising funds have been from issuances of ADRs/GDRs and ECBs. However, not all firms have the access and capacity to raise funds from external sources and equity markets and hence the increasing demand on banks to provide the credit. With the limitation of the source of funds and limited funds at the disposal of the banks, the pressure is on interest rates is bound to increase.

The data released also shows that Commercial Banks’ holding of government securities was 31% of their net demand and time liabilities compared to 36% in last quarter and 39% a year ago. The minimum is 25%, so no issues on this front. However, on the flip side this may put pressure on the auctions of the G-securities hence raising the cost of government borrowings. This is where the problem is. Government uses these funds to meet its investment commitments and non-planned expenditures. With the yields on the G-secs across the maturity increasing the yield curve tends to shift upwards.

With the banks having a higher return by lending to the commercial sector at least a min. spread of 3-4%, they would continue to do so. The sources of funds for banks are borrowings from other banks, RBI and demand and time liabilities in addition to tapping the capital markets both debt and equity. To address the increased demand for the credit, banks may raise the demand and time deposit rates. RBI with its several tools like LAF and MSS attempts to minimize the mismatch in the demand and supply in the short-run. Many banks of late have also raised funds from the equity markets.

Coming to the supply side, bank rate (6% unchanged in current quarterly review) by definition represents the cost of funds for the banks borrowing from the RBI. No increases in SLR and CRR, very rightly, these are not to be changed frequently as these have long-term repercussions on the economy. With the commercial sector primarily relying on bank credit the prime responsibility of the banks and financial institutions is to transfer the funds from the surplus sectors of the economy to the deficit sectors. So the next logical step is to identify the sectors having surplus funds. Given the increased economic activity it is very less likely that the surplus sectors would be easy to identify. Consumer spending is increasing and hence the increased manufacturing activity.

Adding to complexity is rising oil prices. With Oil imports (in quantity) set to increase with increased economic activity coupled with increasing prices would widen the current account deficit. As this happens the central bank uses its reserves to meet its demand for the foreign currency. Hence, rupee depreciates. While depreciating domestic currency increases the realizations from exports this may not offset the demand for imports. In my view current account deficit is a must for the developing country like us provided the imports are productive assets. While debate with regards to the current account deficit continues one has to keep in mind that oil prices are an extraneous variable. Given the volatility in the oil prices expected to continue what options did RBI have? With oil price expected to increase, the inflation is expected to increase and hence its impact on consumer confidence and spending subsequently. No one with confidence can say how and when the equilibrium would be restored.

So what purpose does increasing the repo and reverse repo rate solve? Repo stands for repurchase obligation is a money market instrument, which enables collateralized short term borrowing and lending through sale/purchase operations in debt instruments. In a typical repo transaction, the counter-parties agree to exchange securities and cash, with a simultaneous agreement to reverse the transactions after a given period. So in our case the banks borrow cash to meet their short-term liquidity requirements by selling their holdings of the G-secs to the central bank. From the central bank perspective this is lending of cash against collateralized asset. If the central bank increases this rate as happened in the current quarterly review it signals that central bank is facing liquidity constraints on its part to lend cash further. The increase in rates can be interpreted to discourage excessive lending of cash and or signal increasing cost of executing such a transaction.

I think RBI is right on saying that is only to pre-empt any inflationary pressures.