RBI hikes cash reserve ratio; maintains sanctity of its policy rate

Over the past year or so, the RBI has been using liquidity as a key instrument of monetary policy. In the April policy, it decided to move from a deficit to a neutral liquidity position, to ensure better transmission of rate cuts. Now, by increasing the cash reserve ratio temporarily, the RBI wants to suck out the excess liquidity, to maintain the sanctity of its policy rate. In the two weeks following the Centre’s demonetisation scheme, the yield on the 10-year G-Sec fell sharply by nearly 60 basis points, slipping below the RBI’s key policy repo rate at 6.25 per cent. With a view to prevent a further fall, the RBI has stepped in to draw out the excess liquidity, by requiring banks to maintain 100 per cent of the increase in deposits between September 16 and November 11, as cash reserve ratio with the RBI, effective the fortnight beginning November 26.

While this has already led to the yield on the G-Sec spike to 6.3 per cent levels (above the RBI’s policy rate) it will hurt banks’ margins in the near term.

Why the CRR hike

The Centre’s demonetisation move left banks flush with deposits with no viable credit opportunities to deploy them. Banks have thus been putting the excess funds by lending to the RBI through the reverse repo option and investing in safe government securities.

According to the RBI data, over the past two weeks, banks have been lending funds from around ₹60,000 crore to over ₹1,50,000 crore under the variable reverse repo window across various tenures. They have been earning a good interest on this too. While the fixed reverse repo rate is at 5.75 per cent, the cut-off rate at the reverse repo auctions (variable) has been around the 6.2 per cent mark, due to the excess liquidity in the system.

The aggressive buying of government securities has led to yields falling sharply over the past two weeks. PSU banks have been net buyers to the tune of around Rs 21,000 crore, while private banks have bought around Rs 6,500 crore of government securities over the last two weeks.

If this trend had continued, rates would have dropped even lower. A 25 basis points or higher rate cut (as is the market expectation) in the upcoming monetary policy then would have been meaningless.

To prevent further skewing of short-term rates, the RBI has decided to pull out the additional liquidity.

Banks’ margins to be hurt

Banks need to maintain cash with the RBI on a daily basis. Based on the current CRR requirement, which is 4 per cent, what banks need to set aside is calculated on a fortnightly basis. Currently, banks need to maintain 90 per cent of the requirement on a daily basis.

The additional CRR put in place by the RBI on Saturday, will be based on the incremental deposits between September 16 and November 11. This means that about Rs 3.2 lakh crore of liquidity that will be drained out from the system. While this will help arrest a sharp fall in rates, it may hurt banks’ margins in the near term.

Remember, the amount that banks set aside as CRR, does not fetch them any interest. Hence they will have to bear the negative spread on such deposits. A back of the envelop calculation suggests that banks’ margins may be impacted by about 30-40 basis points this quarter if the move to impose additional CRR is carried on for a month. For now, the RBI has stated that it will review this move after a fortnight on December 9.

Some of this negative spread will however be offset by the 2-3 per cent spread that banks made over the past two weeks under the reverse repo window.

Market players believe that some relief may come through the market stabilisation scheme. These bonds can help suck up some of the excess liquidity. However the Centre has to issue adequate quantum of such bonds for which it will have to incur some cost.