India's quantitative tightening

The persistent gap between credit and deposit growth has perplexed many. Could it be due to shortfalls in money injection by the RBI?

Over the past year, deposit growth in the Indian banking system has persistently lagged loan growth, with deposits growing just 10 per cent, compared to strong 15 per cent-plus growth in banking loans. Such a prolonged gap has not been seen for more than 15 years and is particularly puzzling as every rupee of additional credit adds to money in the system, thus boosting deposit growth as well.

All the money that we see in the economy is either injected by the Reserve Bank of India (RBI) or created by banks. While the commonly understood role of banks as taking deposits from savers and then lending to borrowers is correct, it gives a mistaken view of the sequencing of deposits and loans. The moment a bank gives a loan to a borrower, the latter gets new deposits in her account, and money in the economy goes up. This is how total money, also called broad money, in the economy becomes more than five times the amount of money injected by the RBI, which is referred to as base money or narrow money.

What, then, can explain a persistent gap between deposit growth and credit growth? There can be four possible reasons.

First, when depositors withdraw physical currency, deposits fall: The growth in currency in circulation (CIC) is seen as “leakage’ from the banking system.

Second, when the RBI intervenes in the currency markets to prevent excessive volatility in the exchange rate, it either injects into or reduces money from the system. When it buys dollars to protect the rupee from appreciation, it must sell rupees, adding to the stock of money in the economy. Conversely, when it sells dollars to protect the rupee from depreciation, it buys rupees, reducing the stock of money in the economy. It also calibrates the amount of money in the system by buying or selling government bonds (these are called open market operations, or OMOs).

Third, when government balances with the RBI rise, say, because the inflow of taxes temporarily exceeds government spending, this money briefly goes out of circulation from the banking system.

Fourth, the total amount of deposits is significantly higher than the total amount of banking credit, as banks are required to keep some of their deposits with the RBI (the cash reserve ratio, or CRR), and some need to be invested in government bonds (the statutory liquidity ratio, or SLR). Banks also buy corporate bonds (or government bonds in excess of SLR). Thus, given that loans outstanding cannot exceed around 80 per cent of deposits, the per cent growth due to new loans, which add to deposits by the same quantum, would be higher for loans (given the smaller base), compared to deposits (larger base).

The growth in CIC was normal until the recent policy decision on Rs 2,000 notes, and the government cash balances with the RBI have only fallen in the past year. Thus, over and above the growth differences arising from the arithmetic of the base of deposits being larger than loans in absolute size, a large and persistent gap between credit and deposit growth can only be ascribed to the RBI’s interventions.

Numbers validate this assertion. Over the past year, CIC has been up by Rs 2.5 trillion, and deposits have risen by Rs 18 trillion. On the other side of this equation, bank loans have grown by Rs 19 trillion. Effective injection by the RBI, which forms the balance, is thus well below the run rate of Rs 3 trillion to Rs 5 trillion annually seen in the years before Covid.

Could this be just an adjustment for the significant injection of money during the Covid years, when the RBI was forced to buy dollars to prevent the rupee from appreciating?

We can measure this by looking at the stock of money as a percentage of nominal gross domestic product (GDP). The ratio of broad money (measured as M3) to GDP was around 85 per cent from 2008 to 2016, fell to 80 per cent during demonetisation, and took some time to recover, affected by the deleveraging of Indian businesses. During the pandemic, with the GDP falling and money supply growing due to the RBI’s dollar purchases, the ratio jumped to 95 per cent. Since then, it has been falling steadily, and currently stands at 82 per cent, similar to levels seen a year after demonetisation.

Broad money though can be affected by several factors, not all of which are targeted by the RBI. The RBI calibrates its quantitative interventions on base money (called M0): It is mainly the sum of CIC and banks’ deposits with the RBI; there are “other” deposits with the RBI too, but these are generally small. Growth in M0 has been steady, but after adjusting for the rise in CRR last year to half a per cent above pre-Covid levels, the run rate appears to be inadequate. Not only has the RBI been selling dollars to slow the rupee’s depreciation, but it has also not been an active buyer of government bonds via OMOs.

An economy needs a certain quantum of money to operate efficiently. The ongoing quantitative tightening (QT) in developed economies means a reduction in money supply, given that growth is generally low. In India, due to double-digit nominal GDP growth, money supply must also grow at a corresponding pace, often in double-digits; if the growth in money supply fails to match this pace, it can lead to tightening financial conditions. This would be India’s version of QT. India’s nominal GDP is now very close to the pre-pandemic path, and recent positive surprises to growth also mean increased demand for money.

In its upcoming meeting, the monetary policy committee (MPC) is expected to keep rates unchanged. However, financial conditions may continue to tighten, as the gap between policy rates and effective rates on loans and deposits narrows. While the MPC has raised rates by 250 bps (1 percentage point = 100 bps) over the past year, weighted average lending rates have increased only 104 bps, and weighted average deposit rates have increased only 125 bps. Some of this increase could occur as existing loans and deposits are refinanced: Rates on new loans are up 158 bps and on new deposits 233 bps. Transmission of higher interest rates can accelerate if there is not enough money in circulation.

For now, the withdrawal of Rs 2,000 notes from circulation might ease this pressure. CIC may fall, as not all notes would be exchanged for lower-denomination currency notes; some would be deposited into bank accounts. However, this effect may only last a few months, and measures to boost system liquidity would be needed thereafter.

The writer is chief economist, Axis Bank