For The Government By The Government

The Reserve Bank of India's (RBI) mid-year review of the monetary and credit policy for 2001-02 has been a pleasant surprise for both the bond and the stock markets.

The announcement of the policy sparked off a smart rally in government papers with the yield on the 10-year bond dipping below nine per cent before a bout of profit-booking. Moving in tandem with the yields, forward premiums dipped in the forex markets.

However, while the 200 basis point cut in the cash reserve ratio (CRR) was more than expected, the effective cut works out to be closer to 80 basis points. That's because the RBI has got rid of the exemptions to CRR -- foreign currency non-repatriable balances being one such exception. Because of these exemptions, for the banking system as a whole the effective CRR at present is 6.3 per cent. That will be brought down to 5.5 per cent, releasing Rs 8,000 crore to the banks.

 

At the same time, the rate of interest payable on eligible CRR balances has been linked to the bank rate. Both these measures will help banks' bottomlines. The extent of the gain can be seen by the RBI governor's remark that banks will gain Rs 1,000 crore from the higher interest on CRR balances. A bank like the SBI, which accounts for almost a quarter of the entire banking system, should gain around Rs 250 crore by a rough rule-of-thumb calculation.

The reasons for the CRR cut are pretty clear. Annual inflation is at only 3.2 per cent (taking the wholesale price index on a point-to-point basis), inflation for manufactured products is merely 1.8 per cent, food stocks are at record levels, forex reserves are comfortable, there's nothing to fear on the balance of payments front. And, according to the RBI, central banks around the world have been cutting rates, so why shouldn't the RBI take the opportunity to do likewise?

The RBI has in any case often reiterated its long-term objective of cutting CRR to the statutory minimum of three per cent.

Effect on banks

The lower CRR and the higher interest payable on CRR balances will help financial institutions wanting to convert themselves into universal banks.

The 50 basis point cut in the bank rate will also help banks, because it will cut the rate on export refinance availed by them. That should increase the appetite of banks to finance exporters. But the bank rate is, as the RBI points out, a signal for interest rates in the system, the implication being that banks should reduce their prime lending rates (PLRs).

To be sure, any further cut in bank deposit rates will certainly widen the gap between administered rates on small savings and bank deposits.

Adjusted for tax, the yield on the RBI relief bond is as high as 12.2 per cent! But there will undoubtedly be political pressure to cut lending rates and several banks have already said that they will reduce both deposit and lending rates. Bankers also say that they will take the opportunity to expand their retail portfolio, which will mean lower interest rates for housing and consumer loans.

And, of course, banks' will also benefit from substantial capital gains on their securities portfolio.

Effect on corporates

For corporates, much will depend on whether the rate cut translates into lower PLRs. For larger corporates, which are able to access funds at sub-PLR rates, the lower bond market yields will cut their cost of funds even further.

Large interest-sensitive corporates, which are implementing expansion programmes, will be major gainers. That was the reason cement scrips rose when the policy was announced.

Looking ahead, the policy statement says that the lower interest rates will be maintained, and the market certainly believes that the low interest rate environment is sustainable.

After all, the bond markets were looking forward to below nine per cent yields on the 10-year paper even before the September 11 US attacks. And lastly, with the probability of a substantial overshooting of its borrowing target looming ahead, the main beneficiary of lower interest rates will be the largest borrower -- the government.