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Maintaining interest rate safeguard against shock; Change can be troublesome

The Reserve Bank has been sanguine in not changing the interest rates amid clamour from depositors to raise it and industry to reduce it.
The monetary meet also noted that there might be some drop in the GDP growth because of disruption in money supply. The central bank lowered its growth forecast for 2016-17 to 7.1 percent from 7.6 percent. There are indications that RBI could cut the projections further.
All eyes were set on repo (repurchase) rate. The RBI left it unchanged at 6.5 percent. It set at rest the speculation that banks could reduce consumer lending rates. It was certainly a shock for many as the banks are full with Rs 11.85 lakh crore, almost 76 percent of the scrapped currency, deposits in the wake of demonetization of high value notes.
Many people thought that the flush of fund would be a great help for the banks suffering high NPA of almost Rs 12 lakh crore.
People forget that had those NPAs not been there the banks would have been in a deluge. The floods have their problems, if not managed properly. The RBI finds that the banks themselves could not manage it so even before the monetary policy announcement banks were asked to maintain 100 percent deposits accrued between September 16 and November 11 as incremental cash reserve ratio (CRR).
An increase in CRR means that the banks have to park more money with the central bank. It sucks out liquidity from banking system.
This is a measure to safeguard the deposits on which banks earn 6.25 percent interest from RBI. This prevents the banks from pressure of managing excess funds.
The new situation is another aspect of the demonetization. Those who believed that higher funds were equivalent to higher liquidity had not realized the risk factors.
The credit demand is low as witnessed in October. It means that industry is either having excess funds or having sluggish activities. The latter seems to be true as the industrial index has been indicating.
The strong action could also be aimed at signaling RBI’s reluctance on market interest rates falling too sharply, too soon in the present sluggish global context. The surplus rupee liquidity and sharply falling rates was also creating distortions in the forward premia and indirectly impacting the spot rupee-dollar rates. This liquidity absorption measure could partially reverse distortions.
Since mid-November, a number of banks have reduced deposit interest rates by almost one percent. Some banks have done it a bit more. It leads to less yield on deposits, particularly term (fixed) deposits causing huge loss to all depositors and virtually gives a shock to senior citizens, women and other deprived people who depend on interest accruals.
It also needs to be understood that interest accrual is not an earning. It is only a safeguard against inflation and falling value of deposits.
Bond yields could see knee-jerk reaction of around 15 basis points (bps) if rates had been cut. The issuing market stabilization scheme (MSS) bonds of Rs 300 billion has been put off for this reason.
This indicates that the economy is passing through a fragile situation. If interest rates were allowed to fall further, it could have led to social tension, as the vulnerable depositors rue any fall in interest rates.
The rate cut could have made loans cheaper, as per the general belief. But it is now also being said that lower interest rates leads to easy funding and even swindling of bank funds, opening these to the risk of high non-repayment or NPA.
The RBI though has not stated specifically but is now also considering that lower interests may not be in the interest of the economy and the health of the banks in the long run. There have been suggestions for minimum floor interest rates for deposits; mostly it is quoted at 9 percent. So far RBI has not accepted it.
The fixing of floor deposit rate is suggested as safeguard against seekers of loans on frivolous reasons and ultimate swindlers. A higher deposit rate is also likely to repose faith in the banking system, which has been shaken by a number of large loan scams during 2009-2014.
The RBI stated that so far it could replenish Rs 4 lakh crore new currency, 25 percent of the total demonetized assets. The four currency note presses at Nashik (Maharashtra), Dewas (MP), Salboni (West Bengal) and Mysuru (Karnataka) have the capacity to print about would be 26.66 billion pieces of notes in two shifts if they work all the 24 hours.
It may take may take six months to replenish the stocks. Finance Minister Arun Jaitley says the crisis would be over in three months.
The government is not keen on printing the notes abroad to give a boost to indigenization. Another reason is to prevent printing of fake notes. Earlier, the government had done so and it found that Pakistan was also printing its currency there.
The presses are also facing some raw material shortage.
The problem has also been accentuated as the proportion of the Rs 100 note in circulation by volume has come down from 20.3 percent in 2011-12 to 17.5 percent by the end of 2015-16. During the same period, the proportion of Rs 500 note by volume increased from 14.8 percent to 17.4 percent. The proportion of Rs 1000 note also increased from 5 percent in 2011-12 to 7 percent in 2015-16.
By the end of 2015-16, Rs 500 and Rs 1000 notes made up for a quarter of all the notes in circulation by volume, around 22 billion pieces.
The RBI is in a crisis management situation. Immediately it cannot correct the ratio because of market demand. It is however mulling how to increase the ratio of smaller denomination notes and reduce the supply of high value one.
It has already started the process by printing more Rs 50 and Rs 20 notes. But it would take time to tide over the crisis.
Maintaining interest rates is the immediate step. The micro and macro financial management would take some time to correct many of the logistic anomalies. Overall despite some reaction in the stock market, there is agreement that RBI has taken the correct step to save the economy from sudden shocks.

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