CRR positive but government is the cause for no repo cut

The markets are enthused by the CRR cut with rally in equity, currency and bonds. Equities and the Rupee are up by over 1% while bond yields are down by 4bps post CRR cut. The government has played a spoilsport to a repo cut in this policy, which if it had come through would have led to stronger rallies in the markets.

The market rally has more steam left given expectations of further rate cuts down the line but the fact that RBI is now becoming more tied to the government is worrying and is a factor to watch out for in the coming months.

Liquidity conditions forced RBI to cut CRR (Cash Reserve Ratio) by 50bps in its third quarter monetary policy review on the 24^th of January 2012. Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) of the RBI averaged over Rs 150,000 crores on a daily basis last week. The demand for funds from the RBI had gone up Rs 70,000 crores over the last four months, despite RBI infusing Rs 61,000 crores of primary liquidity into the system through OMO (Open Market Operations) bond purchase auctions. The government has been drawing on its overdraft limits from the RBI and was overdrawn by around Rs 15,000 crores as of 13^th January 2012. RBI’s bond purchases and government spending have failed to bring down liquidity deficit. Liquidity at Rs 150,000 crores deficit is higher by Rs 80,000 crores over RBI’s comfort zone of around Rs 60,000 crores to Rs 70,000 crores deficit. Hence the CRR cut.

RBI has been maintaining that CRR is a monetary tool and indicates its monetary stance. In fact RBI has sounded that the CRR cut is a precursor to cuts in repo rate down the line. RBI cited reasons of a sticky non food manufacturing inflation, which at over 7% levels is higher than the long term average of 4% for not cutting repo rates. However, the underlying reason for the RBI holding on to Repo rates is the government’s utter mismanagement of its finances.

The government is borrowing Rs 93,000 crores more than planned in fiscal 2011-12. The government’s fiscal deficit is expected to go up by 1% from budgeted levels of 4.6% due to higher subsidy payouts. Subsidy payouts has led to the revenue deficit to touch 91.3% of budgeted target in the April-December 2011 period and the fact that the government is unable to control its revenue deficit makes spending on productive investments less. Lower capital account spending leads to supply deficiencies leading to higher prices.

The RBI has been forced to step in to contain the impact of higher government borrowing on both liquidity and bond yields. RBI cited tight liquidity conditions to undertake a series of bond purchase auctions, which in effect is turning out to be back door deficit financing.

The case for a repo cut is strong. GDP growth is revised downwards from 7.6% to 7% for fiscal 2011-12. Planned corporate investments have declined by 77% in the second quarter of 2011-12 on a year on year basis. Credit growth at below 16% is well within RBI’s target of 17% for 2011-12. Global economic conditions are expected to weaken with problems in the Eurozone. Inflation is expected to trend down to below 7% in March 2012 as per RBI’s expectations even though there is some upside risks to inflation in the form of higher power tariffs (due to increase in input costs such as coal prices) and pass through of rupee depreciation into the economy. The Rupee is still down over 10% against the US Dollar over the last four months despite a rally of close to 5% month to date.