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Tuesday, January 24, 2012

Did the stock market over-react to the 50 bps CRR cut by RBI?

The short answer to the question is: Yes. The CRR rate cut is good news, but not great news. Great news would have been a cut in the repo and reverse repo rates. Now, the long answer.

Imagine that you are a farmer in central India, and it is the middle of April. With poor access to irrigation facilities, your crop is dependent on the monsoon rains. Your cousin from the nearby town comes to visit you and mentions that it was announced on the TV that monsoon may set in a week early in the middle of June instead of the third week. No doubt, that would be good news. But the rains will still be two months away.

RBI's announcement is somewhat similar. The CRR rate cut is an indication that repo and reverse repo rates may be reduced two months down the road. So, today's high volumes may be a sign of a buying climax.

What is the CRR and what purpose will be achieved by cutting it from 6% to 5.5%? Cash Reserve Ratio (CRR) is a percentage of the total deposits in a bank that has to be maintained as a 'reserve' with the RBI. It is one of the monetary instruments used by the central bank to regulate the money supply in the financial system.

Due to the aggressive interest rate increases by the RBI to contain inflation, growth has started to slow down. In fact, the RBI has now set the GDP growth target for 2011-12 at 7% - down from earlier revised target of 7.6%. Much lower than the glory days of 9-10%. India Inc. have been complaining that growth was being sacrificed to control inflation. Now that inflation rate has finally started to moderate, RBI has taken the first step by increasing the liquidity in the financial system.

How does it work? Let us say, a bank has Rs 10,000 Crores as deposits. A 6% CRR implies that Rs 600 Crores have to be maintained as a 'reserve' with RBI. That means, the bank has access to only Rs 9400 Crores that it can give out as loans. A 50 bps (i.e. 0.5%) cut in the CRR leaves the same bank with access to Rs 9430 Crores to deploy gainfully. On the extra Rs 30 Crores, the bank can expect to generate an additional Rs 3 Crores in profit.

The overall cash infusion into the banking system is expected to be about Rs 32,000 Crores, which can be loaned out to generate a profit of say Rs 3200 Crores. Not a small sum, but not a king's ransom either. Now you know why the bank stocks rose today. But that is the theoretical view point. What is likely to happen in real life?

Is India Inc. going to break down the doors of banks to apply for loans? Highly unlikely. Remember that the interest rates remain just as high as it was two months back, when no one was taking loans and were postponing capital expenditure. Banks are also struggling to contain their NPAs and have become quite rigid in doing due diligence before handing out loans. Add to that the likelihood of the inflation fires getting stoked by the excess liquidity in the system. There is also 'hidden' inflation due to large subsidies.

All in all, definitely not a cause for celebration. The RBI governor clearly put the ball in the government's court by pointing out that fiscal profligacy is one of the major causes of inflation. Unless core inflation falls further, do not expect a cut in the repo or reverse repo rates in a hurry.

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1 comment:

Ram Kumar said...

Thanks Subhankar, another useful information!