The Reserve Bank of India (RBI) on Monday cut the cash reserve ratio by 25 basis points to 4.5 per cent, increasing liquidity flow into the economy. However, it left the key bank rate and the repo rate unchanged, saying inflation risks as well as growth risks persist and the primary focus of monetary policy is fighting inflation, a move that many called conservative.
"In the current circumstances, lowering policy rates will only aggravate inflationary impulses without necessarily stimulating growth," RBI governor D. Subbarao wrote in the monetary policy review.
After falling a bit in the previous month, inflation rose to 7.55 per cent in August, driven by higher prices of potatoes, wheat and pulses, which rose due to poor monsoons.
Besides improving India’s growth outlook, the CRR reduction will release Rs 17,000 crore into the economy.
The CRR stipulates the minimum proportion of deposits that banks must hold with the central bank. When the RBI increases the CRR, banks have fewer funds to lend or invest since they have to park more money with the RBI.
Finance Minister P. Chidambaram said RBI’s move showed it was “supportive of what the government is doing”, and said it the CRR cut was a “small, but welcome step”.
The bullish markets, which were rooting for a cut in the key lending rates, instantaneously shed intraday gains with the BSE Sensex falling 150 points while the NSE Nifty slipped below the key 5,600 mark. The rupee pared gains and traded at 53.87 to the dollar.
“I think the RBI has taken a cautious stand considering the inflation. Therefore, a reduction in the repo rate would have shown a strong change in policy, which it hasn’t done. But at the same time it cut CRR by 25 bps which will help liquidity and help banks lend,” Dr C. Rangarajan, chairman of the Prime Minister’s Economic Advisory Council, told NDTV.
Diwakar Gupta, managing director of State Bank of India, said: “This is much better than a repo rate cut. A reference rate cut does not give so much release to banks as much as a CRR.”
The recent upward revision in diesel prices is a significant achievement, the central bank said, and the diesel price hike and LPG subsidy cap will put pressure on inflation in the short term. In the medium term, a cut in fuel subsidy will strengthen macroeconomic fundamentals.
But, along with the measures unveiled Friday to liberalize ownership of supermarkets and other industries, it shows the government is serious about fiscal consolidation and encouraging investment, and may make Mr. Subbarao more inclined to ease monetary policy sooner than later.
Montek Singh Ahluwalia, deputy chairman of Planning Commission, said: “The CRR cut is a welcome step in the right direction. It’s a misnomer that repo rate cut gives access to more liquidity. The CRR cut should be looked at in totality with steps taken by the government. This will build confidence. Several steps are needed to revive growth. Monetary policy is one of the step, which can be changed in six months if need be.”
The CRR cut may lead to banks charging lower interest rates on loans because they have more money to lend.
There are expectations that the CRR reduction sets the stage for a cut in key lending rates by the central bank at its next policy review on October 30, 2012.
“I see RBI's October 30 reaction to be more supportive. The government is expected to take additional policy measures between now and October 30… this will be a part of the fiscal correction,” the Finance Minister said.
Keki Mistry, CEO of HDFC, India’s largest mortgage lender, said: “The CRR cut is more welcome as it gives banks more money and pumps in liquidity. If the RBI looks at more rate cuts, then we will look at bringing our rates down.”
“For us, the cost of funding comes down and, hence, we will pass it on to consumers. Short-term funding rates are low. But long-term funding rates are still high. Now, we are expecting them to start inching downwards if government continues its action,” he added.
Foreign rating agencies said the CRR cut was a welcome move but much remains to be done.
After the government announced a hike in the price of diesel and followed it up with some big-ticket reforms late last week, India Inc. had been clamoring for a rate cut from the central bank. Amid slowing growth and downgrades from global investment banks—some even threatening a downgrade to junk status—the RBI has steadfastly said controlling inflation is its key priority.
“I was expecting some kind of reciprocation from RBI after a lot of changes last week. It just validates the case that if RBI had made it contingent on government action, it was willing to reciprocate,” said Abheek Barua, chief economist at HDFC Bank.
Last week's policy actions made a significantly contribute in mitigating growth risks, the RBI said today, adding that the government's actions take the economy to a higher sustainable growth trajectory.
With inputs from Reuters