Why the RBI preferred an SLR cut

August 2, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The first quarter review of monetary policy did not create any ripples. The stock market remained flat and investors and consumers showed little interest. That was because RBI Governor Duvvuri Subbarao had made enough noise earlier that the time was not right and conditions were not suitable for a rate cut.

Time is not right simply because the original cause for the increase in the rate still persists. Inflation is what the RBI had set out to correct. Even in June, it was well over 7 percent and would quite likely scale up further with the monsoon being late and irregular and consequently agricultural production likely to drop.

The RBI did not have to wait for two and a half years to realise that repo is not really the solution to inflation. The RBI had targeted repo because the interest rate that the banks charge remains above the inflation rate. The real rate of interest — as the difference between the two is called — has to be positive to ensure that people do not give up their savings habit and debtors are not subsidised by creditors.

There was a more relevant reason why the RBI did not cut the repo rate. Like a compulsive spendthrift, the government has been borrowing hugely to cover the deficit between income and expenditure. This borrowing by the government can itself push up the rate of interest for the private sector even if the RBI volunteers to cut the repo.

The cut in SLR has to be seen in that context. Subbarao is keen to ensure that “liquidity pressures do not constrain the flow of credit to the productive sectors of the economy”. That also implies that the government should not have easy access to funds to cover its bloating budget deficit.

The RBI could have reduced CRR but preferred to reduce SLR. The first would have meant that commercial banks would have got additional liquidity free of cost. If liquidity alone was the issue, the RBI can replenish it using open market operations. The second would mean that banks will shift their portfolio in favour of the private sector against the government or to the more productive from the less productive sector. That is the real stance of the monetary policy.

With the reduction of SLR, the RBI is shrinking the market for government securities and simultaneously enlarging availability of credit to the private sector. With that, the cost of funds to the government will increase and the rate charged by banks to the private sector decreases.

The RBI has in a subtle way used its power to discourage government borrowing and ease borrowing by the private sector. If commercial banks reduce rate on credit, as the SBI has already done, the RBI would have achieved much more than what a cut in repo would have done. But the reality is that the RBI monetary policy will do little to suppress inflation or lift growth. The failure of the monsoon will hit both.

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