December 09, 2019
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The Scent Of A Crash

The RBI is scripting a tale of economic imbalance with a disastrous end

The Scent Of A Crash
Illustration by Sorit
The Scent Of A Crash
If one ever needed proof that stubbornness does not pay, Dr Y.V. Reddy, the governor of the Reserve Bank, has just provided it. On Tuesday he announced another increase in the Cash Reserve Ratio (CRR)—the amount of depositors' money that commercial banks have to deposit with the Reserve Bank, to 7.5 per cent. This is the fourth time this year. His justification for the increase is that money supply is growing dangerously fast and an enormous 'liquidity overhang'—money that is accumulating in the banking system with no takers—has developed. It is imperative to impound this money lest it start generating inflation. Increasing the CRR by half a per cent and thereby taking another Rs 20,000 crore out of the credit base of the banks is a quick and convenient way of doing this.

At first glance, the data seems to vindicate Reddy's move. Money supply has increased by 21.8 per cent in the past year against 18.9 per cent in the same period of '05-6. Deposits with the commercial banks have grown by 24.9 per cent against 20.4 per cent. And the liquidity overhang has grown from Rs 85,779 crore in '05-6 (October to October) to a whopping Rs 2,22,582 crore. But the RBI's own half-yearly review of the economy shows that it is itself the author of this growing imbalance.

The main cause of the surfeit of liquidity is a $84 billion increase in the country's foreign exchange reserves in this calendar year, from January to October 19. It is the rupee released into the economy when the RBI buys this foreign exchange that is swelling the banks' liquidity. This is not money that Indians have earned. It is mostly 'hot' money that has been attracted to India by the scent of a kill. Reddy's successive increases in the CRR have provided the bait. By taking money out of circulation they have pushed up interest rates. By June '07 the Prime Lending Rate (PLR)—at which banks lend to blue-chip companies—was a full two and a half per cent above what it had been a year earlier. Since inflation had also begun to subside, the 'real' lending rate in India was almost 4 per cent higher than in the OECD countries.

So hot money began to roll in and forex reserves rose by around $22 billion between January and March. But this was only a curtain-raiser. After Reddy raised the CRR a second time in April, the sharks really began to move in. Between April 1 and October 19, the reserves rose by another $62 billion. Thus, the total inflow of hot money this year is getting dangerously near $100 billion!

This is proving a recipe for disaster. By Reddy's own figures, it has caused the rupee to appreciate by 10.3 per cent against the dollar, 2.5 per cent against the euro, 5.4 per cent against the pound, and 7.1 per cent against the yen in just six months. The appreciation is playing havoc with the country's foreign trade. Export growth has slowed down from 27 to 18 per cent and this figure is bound to drop further as orders placed last year get completed. What is far more alarming, non-oil imports have grown by 44 per cent against only 10.9 per cent last year.

But in August, Reddy raised the CRR for a third time. And the grounds he gave for doing so were the same ones he gave earlier this week. But the accelerated rise of reserves during the last six months shows that his cure has only worsened the disease. The rise in interest rates is also playing havoc with the domestic economy. In July, the rate of growth of manufacturing fell to 7.1 per cent, half of what it had been in the same month of '06.

Not surprisingly, the consumer durables industries are the worst hit. In the first five months of this year, production has remained a solid 6.2 per cent below last year's level. Housing loans have begun to go sour. Three banks sold off Rs 800 crore of bad housing loans as far back as April.

The RBI's figures for bank credit show that further declines in growth are inevitable. Between April and August, it has grown by a paltry Rs 32,000 crore. In percentage terms, this is one-third of the increase during the same period of '06. If the ratio is maintained, the increase in bank credit this year will not exceed Rs 1,50,000 crore against Rs 4,00,000 crore last year. The growth of industrial production is likely to slow down in the same ratio.

Since August, rather than bring down the CRR and allow the banks to lower their lending rates, Reddy has been busy putting out the bush fires he has himself lit. In that month the RBI put curbs on borrowings by Indian firms abroad to slow down the inflow of dollars. In September, the government asked the banks to lower their interest rates on housing loans. In early October, it let it be known that it was contemplating curbs on foreign investment in the share market. But none of this is working. The balance of payments deficit on the current account continues to grow and industry continues to slow down. Foreign money continues to flood the stockmarket and the Sensex has crossed the 20000 mark. The crash, when it comes, will be terrible.
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