SLR cut to push govt to borrow at market rates

Rajan's move holds fiscal consolidation message for the government, targets better credit availability for the private sector

Reserve Bank of India (RBI) governor Raghuram Rajan is known for his surgical precision when it comes to targeting problems with customised solutions. By reducing the statutory liquidity ratio (SLR) of scheduled commercial banks from 23 per cent to 22.5 per cent, governor Rajan will not only release more funds for the private sector, but will also push the government towards fiscal discipline. Under SLR, banks are mandated to park a certain portion of their liabilities in government securities.

The central bank is trying to pre-empt the fiscal consolidation by the government, by pushing it to borrow at market rates instead of the negative interest rates that it is currently borrowing at. Ritika Mankar Mukherjee, economist at Ambit Capital, says the core message sent out by RBI with the SLR cut is that it is willing to make credit available to the private sector.

While the move may release some liquidity in the system for the private sector, the impact of the SLR cut is expected to be far-reaching on the government, since investments of most banks in such liquid assets is running four to five per cent over the prescribed norm. The RBI has taken note of the the Urjit Patel report, which says: “The SLR prescription provides a captive market for government securities and helps to artificially suppress the cost of borrowing for the government, dampening the transmission of interest rate changes across the term structure.” A lower SLR would lower banks’ investments in government securities. Also, the RBI is gradually attempting to get banks to move their government securities holdings from held-to-maturity to mark-to-market.

The government has a captive investor base in banks and, due to regulatory reasons, ends up borrowing at artificially low rates. Borrowing at lower rates also incentivises the government to borrow more. With banks moving away from held-to-maturity to mark-to-market, the government will eventually have to borrow at market-determined costs. The RBI’s move is not to increase liquidity for the banking sector, says Dhananjay Sinha of Emkay Global. If SLR becomes marked to market, then the government will have to borrow at market determined rates and that will push fiscal consolidation, he explains.

By keeping key rates unchanged, the RBI has given the government room to act on fiscal consolidation. The 4.1 per cent fiscal deficit target set by the UPA regime for FY15 in the Interim Budget is unrealistic, as tax collections are growing at a much slower pace than estimated in the Interim Budget.

Government data show it has managed to cobble together a surplus of Rs 90,000 crore, which is unprecedented. Also, the Q4 FY14 subsidy bill has been pushed to the current fiscal, which has also facilitated the surplus. Economists expect the government’s fiscal deficit to be closer to 4.5 per cent levels in FY15. Given that fiscal deficit is unlikely to surprise positively by coming below four per cent levels any time this year, the chances of a rate cut are low, as inflation may remain sticky..

Inflation continues to be a surprise for the economy. If inflation comes down to RBI's targeted levels by January 2015, then there is a chance of rates easing later in the fiscal. However, inflation may see a bump up in the fourth quarter of FY15 after coming down from the current 8.6 per cent levels seen in April. If there is an El Nino like situation and the government’s response is not adequate leading to higher inflation, there is an equal chance of a rate hike.