The mid-quarter review of the monetary policy is scheduled for March 15 and it was widely expected that Reserve Bank of India would cut rates then.
However, on Friday evening, the central bank sprung a surprise by cutting cash reserve ratio (CRR) by 0.75 per cent to 4.75 per cent.
CRR is the percentage of deposits that commercial banks have to keep aside with the central bank. Central banks use CRR rates as a tool to control the money supply in their battle against inflation. This is also used to control over-heating of an economy where expansion takes place on cheap borrowed money.
Read the industry reaction
Banks are finding it difficult to keep up with the demand for money that is surging due to advance tax payment obligations of corporates. Corporate tax payers have to pay their last instalment for the financial year on 15 March 2012. The RBI action will allow banks to lend the money that would otherwise lie idle to these borrowers.
Alarmed by the liquidity deficit, which had banks borrowing up to Rs 1,20,000 crore through the overnight window or the liquidity adjustment facility (LAF), the RBI had cut the CRR by 0.50 percent in the January 24 policy review to 5.50 percent.
However, in spite of the CRR cut which infused about Rs 32,000 crore into the system, banks continued to borrow over Rs 1,00,000 crore from the LAF (liquidity adjustment facility) corridor, much above the RBI's stated liquidity deficit comfort zone of Rs 60,000 crore.
This is despite RBI buying government securities from banks and injecting Rs 1,25,200 crore into the system through the so called ‘open market operations’.
Two weeks ago, RBI deputy governor Subir Gokarn hinted at an action.
Here are pointers that could help explain the reaction:
• The CRR cut means banks have more money to lend at the same cost. This reduces cost of funds for banks. Banks are likely to use the CRR cut to improve their own profitability. This should be positive for bank sector shares. Some banks may be able to pass on the cost to their customers.
• However, RBI would have to watch crude prices. Brent crude prices, which occupies for two thirds of the country's imports, have moved up to over USD 125 a barrel, at a ten-month high, against the RBI's baseline assumption of USD 110. RBI deputy governor had said that the central bank would continue monitoring the number.
• Rising oil prices may not give flexibility to RBI to cut repo rates. These are rates at which banks borrow from RBI. There is a potential for inflation surge and central banks have to battle that as a priority.
• RBI has said that the cut in CRR by 0.75 per cent should be considered as a reinforcement of the guidance that future rate actions will be towards lowering them. When interest rates are high, an investor’s or lenders ability to take risks declines. The RBI is clearly indicating to them that it is time to invest for growth.
• The monetary tightening (hiking interest rates 13 times since March 2010) made it difficult for companies to borrow. Banks were cautious and not willing to lend to companies wanting to expand. The RBI signal means that banks would be more willing to lend money now than before. This should allow businesses to plan new projects or execute those held up due to lack of financial resources
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