RBI: Monetising the Tale of Two Governors.

Reserve Bank of India (RBI) announced its second quarter monetary policy on the 29th of October. RBI led by younger and suave governor, Raghuram Rajan, did exactly what his immediate predecessor and more staid, Duvvuri Subbarao, was wont to do; not to let lose sight of the inflationary pressures. He increased the REPO rate, the rate at which central bank lends funds overnight to banks, by 25 basis points (bps) to 7.75%. Subbarao too had hiked REPO rate several times to moderate inflationary pressures. However, the same action from two RBI governors received quite separate reception from Markets, Analysts, Industry and Columnists. Subbarao was faulted time and again for not paying required attention to the anaemic growth of the Indian economy; and for being unduly and narrowly fixated on inflationary pressures. Critics said that inflationary pressures were on account of supply side constraints -falling production, and not due to rising demand expectations. Partly this carried some weight in view of the negative growth posted by automobile industry and manufacturing sector. However, the sticky food and non-food inflation as measured by Consumer Price Index (CPI) worried Subbrao as it has Rajan. However, while Subbarao was skewered for his alleged hawkish anti-inflationary posture, Rajan received for same action a very indulgent reception. What could explain this preferential treatment to the new RBI governor?

Is it because Rajan is younger and more photogenic? Or is it because he is a product of prestigious IIT/IIM, has worked as chief economist with IMF, and is a professor at University of Chicago Business School, albeit on a long leave of absence? Subbarao worked a long innings as a senior bureaucrat with the Government of India in its powerful Indian Administrative Service. Is the anti-bureaucracy and pro-private manager bias at work here? Or is Rajan expected to be more influential with international financial institutions and foreign central bankers because of his high profile international exposure? It may be any of these or may be all of these factors in some measure; but despite making money dearer the stock market gave Rajan thumbs up with Bombay Sensex closing near record all-time high. Rajan has been in fact twice lucky in a short span of two months. When he took over from Subbarao in early September, Indian Rupee had been behaving as if it has fallen in a bottomless pit viz-a-viz theUS greenback. The Indian government and industry was in panic mode with Finance Minister almost daily issuing an appeal not to panic with an assurance that Indian economy is doing far better than the treatment meted out to it by the falling Rupee. Currency markets are the largest and dwarf all other markets by whole nine yards. Since markets essentially move on sentiments, mostly irrational, no country’s central bank can withstand a run on its currency. Fortuitously for Rajan, Forward Open Market Committee (FOMC) of the United States’ Federal Reserve, decided that the state of US economy doesn’t warrant the easing out of Quantitative Easing (QE) -the huge pumping of dollars into the banking system in USofA, for the moment. In fact, the expectation around the world was to the contrary, and markets everywhere were showing their nervousness before the announcement. FOMC news calmed the markets, and Foreign Institutional Investors stopped pulling out their investment dollars out of India. In turn, that calmed the Rupee’s fall, and in fact unexpectedly it started gaining in strength reversing more than 55% of its recent fall. The basic prognosis of the Indian economy, two of its worrisome indicators -current account deficit (CAD) and fiscal deficit (FD: Fiscal deficit touches 76% of annual budget estimate in just 6 months), have shown no reversal of fortunes to warrant either precipitous fall or the subsequent handsome gain in the exchange value of Rupee. What covered Rajan with unexpected glory just a few weeks into his new job could quite easily be attributed to the decision of FOMC. Rajan proved second time lucky when FOMC decided to continue with its inaction with regard to QE when it met on 30thOctober. That is what turned BSE-Sensex euphoric with easy US money skimming profit opportunities in India once again.

Probably secretly grateful to the US institution, Rajan made some crucial disclosures for the first time at an event organized by Institute International Finance, a global banking lobbying group, in Washington D.C. The rock star adulation showered on him prompted Rajan to say at the event: **Expectations are high. Clearly I am not a superman. There is a little bit of euphoria in India,… We can do more what a central bank in an industrial country can do. But we can in some ways do less. On where we can do more, clearly there are a lot of low hanging fruit in the financial sector,… The banking sector reform, in particular to those facilitating entry of foreign banks in India in a “big way” is part of the five pillars of reforms, including monetary policy framework, which the RBI is going to implement in the next few years,… That is going to be a big big opening because – one could even contemplate taking over Indian banks, small Indian banks and so on,” Rajan said, adding that the policy framework for the entry of foreign banks in India is likely to unveiled in the next few weeks**. This was big ticket announcement that Rajan made on a foreign soil. A lesser mortal would have invited the wrath of media and commentators for the impropriety of the choice of the venue to declare such far reaching measure for the first time. However, there was not even a whimper of protest in Indian media. International banks like Citi Bank, Royal Bank of Scotland, and others, apart from major investment banks led by Goldman Sachs, did not cover themselves in glory in the financial crisis, which brought the world economy down almost to a grinding halt. In fact, these very giant banks were responsible for the crisis by creating runaway asset bubbles in housing markets by creating exotic instruments called Collateralized Debt Obligations (CDOs), whose underlying “assets” or risks even their creators did not understand.Moreover, USA corporates including banks are myopically focused on short term returns while leaving the long term open to toxic hazards because of the practise of linking top management compensation to quarterly results. This has created a culture that is unwary of risks. Giving unconstrained access to foreign banks would blindly import their pernicious culture and questionable practises, and thereby expose Indian economy to unforeseen risks far beyond her capacity to navigate. One of the reasons why Indian banks escaped the tsunami of global financial crisis was the superb regulatory role played by RBI with Subbarao at the helm. The “Do More…. Do Less….” abstract statement of Rajan would add these worries. What he left unsaid but is clearly discernible from the primacy he gave to monetary policy reforms is: Do More means Liberalise More. Do Less means Regulate Less. This is a sure recipe for disaster when ethics are foreign to big ticket names in foreign banks: *Several banks (including HSBC, UBS and Credit Suisse) have recently paid billions of dollars in fines for their alleged role in Libor rate-fixing scandal, money laundering and other corrupt practices. The JPMorgan Chase has been associated with several trading scandals in the recent past and has agreed to pay $13 billion to settle claims that it sold bad mortgages to two government agencies of the US (Fannie Mae and Freddie Mac)”.
Foreign banks are no strangers to India. Many of them have operated here for decades, some even a century. They have remained principally urban centric and they operate in most of the highly lucrative sectors. Have they brought in much needed competition or innovation to India? If they have, it has been a well-kept secret. Have they faced any obstacles or discrimination in India? On the contrary, they have received a much better treatment than what even World Trade Organization (WTO) mandates. **Currently, there are 41 foreign banks operating in India with 323 branches and 1414 ATMs. Another 46 foreign banks operate through their representative offices. It is often overlooked that even without branch licenses, foreign banks have been expanding business through off-site ATMs, non-banking finance companies and off-balance sheet exposures.  As per on-balance sheet businesses, foreign banks own 8 per cent of the total banking assets in India. However if one includes off-balance sheet businesses (e.g., forward exchange contracts and guarantees), then the ownership patterns dramatically reverse as foreign banks are the biggest players in the off-balance sheet businesses with a combined market share of 62 per cent in 2012. The total share of foreign banks as a percentage of the banking assets of India (both on- and off-balance-sheet items) was more than 40 percent in 2012.  As per India’s commitment at the World Trade Organisation, licenses for new foreign banks may be denied when the share of foreign banks’ assets in domestic banking system (including both on- and off-balance-sheet items) exceeds 15 per cent.Till date, India has not invoked the WTO commitments to deny the entry of foreign banks in the country. Rather, the number of branches permitted each year to foreign banks has been higher than the WTO commitments of 12 branches in a year.  In addition, foreign banks in India are free to undertake any banking activity (e.g., wholesale, retail, investment banking, foreign exchange, etc.) which is allowed to domestic banks. In Singapore, China and the US, strict restrictions have been imposed on the kind of businesses that could be carried out by foreign banks within their jurisdictions**. When the focus of foreign banks is on lucrative Niche Banking, how could they be expected to contribute to much talked of financial inclusion of some 500 million Indians without access to banking? Their “performance” in even opening *no frills* bank accounts has been abysmal. Such *plain vanilla* bank accounts have been made the lynchpin of the Adhaar Cards issued by Unique Identification Authority of India (UIDAI). Rajan’s announcement should have, therefore, received far more scrutiny than it did. In fact, the issues his announcements have raised need to be debated threadbare in every economic and policy making forum including India’s parliament before he is allowed a free run into banking disaster.
Coming back to RBI’s latest monitory policy announcements, how are the different rates affected.
·        REPO Rate: To 7.75% from 7.50%.
·        Reverse REPO Rate: To 6.75% from 6.50%.
·        Marginal Standing Facility (MSF) Rate: To 8.75%from 9.00%.
·        Notified Amount for Term REPO: To 0.50% of net demand and time liability (NDTL) of the banking system.
Those who need some background on banking terminology, see the glossary included at the end. In general, the Monetary Policy governs the supply of money and cost of money. REPO, REVERSE REPO, and MSF Rates are the tools used by the central bank to influence the cost of borrowing money. By making money dearer, it hopes to check the demand for money; and vice versa. However, it has less direct impact, but affords more flexibility depending upon the profitability and needs of individual sectors. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) have the effect of sucking out or pumping in money into the banking system directly by setting aside a percentage of bank money into stipulated categories. Employing these latter tools is akin to using a sledge hammer, whose effect is felt across the board. When supply of money is curtailed, it automatically increases the cost of funds available for lending across sectors. Reducing the MSF Rate looks like a cosmetic measure just to offset at face value the impact of raising REPO rate –a measure that came to be reviled much in the closing years of Subbarao’s tenure. What impact this has on inflation we will soon know.
Glossary of Banking Terms:
REPO Rate: Repo rate is the rate at which the central bank of a country lends money against COLLATERAL (usually government bonds) to commercial banks in the event of any shortfall of funds. Repo rate is used by monetary authorities to control inflation.
Description:In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.
Reverse REPO Rate: Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country.
Description:An increase in the reverse repo rate will decrease the money supply and vice-versa, other things remaining constant. An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market.
The central bank takes the contrary position in the event of a fall in inflationary pressures. Repo and reverse repo rates form a part of the liquidity adjustment tools.
Marginal Standing Facility (MSF) Rate: is the interest rate charged by central bank to lend money to banks without COLLATERAL (of approved bonds/securities) to meet emergency fund shortfalls (Liquidity Adjustment Factor-LAF). MSF Rate is >> REPO rate. (Comment: Borrowing at MSF rate was rampant to seek arbitrage opportunities when Rupee was falling endlessly and RBI had hiked MSF rate to make arbitrage less attractive. Since Rupee is now stable, RBI has reduced MSF rate while hiking REPO rate to curb inflation).
Overnight Rate (OR): is the rate at which banks borrow or lend between themselves. The ceiling and floor for OR is determined by REPO and Reverse REPO rates.
Cash Reserve Ratio (CRR): Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country.
Description: The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or parked with the Reserve Bank of India. The aim here is to ensure that banks do not run out of cash to meet the payment demands of their depositors. CRR is a crucial monetary policy tool and is used for controlling money supply in an economy.
CRR specifications give greater control to the central bank over money supply. Commercial banks have to hold only some specified part of the total deposits as reserves. This is called fractional reserve banking.
Statutory Liquidity Ratio: A specified minimum proportion of Banks’ net demand and time liabilities maintained as liquid assets in the form of cash, gold and un-encumbered approved securities.
SLR restricts or loosens the bank’s leverage (remember Fractional Reserve Banking) to pump more money into the economy, whereas CRR sucks out or infuses money to affect money supply.
To meet SLR, banks can use cash, gold or approved securities that are earmarked but remain with bank; whereas CRR has to be only cash/deposit maintained with RBI.
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