Liquidity, inflation and economic growth

The mid- term review of monetary policy by the Reserve Bank has not brought out any drastic changes to contain inflation perhaps keeping in view the need to support the economic growth envisaged at around 9 percent and the moderated level of inflation although it continues to remain in the uncomfortable zone. The problem of liquidity of banks is well recognized and the measures introduced to come to banks’ rescue include reduction of Statutory Liquidity Ratio of Scheduled Commercial Banks from 25 percent of their Net Demand and Time Liabilities to 24 percent with effect from December 18,2010 and conduct of open market operation auctions for purchase of Government securities for an aggregate amount of Rs 48,000 crores in the next one month. These measures at best may improve the cash crunch position of banks but cannot improve their liquidity position on an endurable basis.
The present liquidity shortage with the banks is very tricky. Disinvestments by the Government have taken away the deposits of the banks. The advance payment of taxes by the corporate and high net worth individuals also has affected the deposits of banks. The negative rate of return on deposit interest rate because of high level of inflation persisting for quite some time seems to have prompted investors to divert their deposits from banks to other forms of assets such as post office savings, real estate, gold and other commodities.
The funds of Government lying with the Reserve bank at around Rs 85000 crores without earning any income and the borrowings of the Government at a cost from the Reserve bank do not seem to be good funds management and the adverse effect is on the economy. The utilization of the surpluses will ease the liquidity to a great extent. In this context, the measure announced by the Reserve Bank to reduce the Statutory Liquidity Ratio by one percentage point to 24 percent on a permanent basis is a well thought out plan and helps banks to widen their commercial credit instead of locking the funds in Government and other approved securities. To this extent the preemption of bank deposits for the Government Securities goes and the banks can have an improved funds management.
The Cash Reserve Ratio is kept unchanged at 6 percent. Banks can derive the full benefit only if they improve their deposits substantially. The banks’ loss of income on these Reserves and additional expenditure that they have to incur on their borrowings from the Reserve Bank under REPO at 6.25 percent affect not only their liquidity but also their profitability. The only way to come out of this situation is to considerably enhance their deposit base for which banks have to work hard and find innovative ways. The Reserve Bank’s Governor’s call to banks made during the Bank Economists’ conference held recently in Mumbai to enhance deposit interest rate and reduce the interest rate on loans assumes significance and needs to be seriously pursued. The NIM needs to be brought down and the volume of business turnover has to be augmented to improve the profits. Both balance sheet and off balance sheet size have to increase with an eye on improved earnings not counting much on NIM.
Some of the ways to enhance banks’ business turn over would be to seriously step up financial inclusion, tie up their business with tourist operators in the context of increased interests visible in national and international tourism, taking advantage of investors new found interest in commodity market particularly gold and derivative trading in foreign currencies and encouraging transactions through banks and banking instruments like cheques, demand drafts, plastic cards, mobile and internet banking. The public preference for cash needs to be drastically curbed to improve the bank deposits. Management of advances portfolio keeping the non performing and the potential non performing advances as low as possible by avoiding aggressive and speculative lending will also help the banks to improve their liquidity and profitability.
The high level of inflation continues to be a cause of concern and there are no signs of it coming down. The increase in oil prices both in domestic and international markets, continued high prices of food items despite a favorable monsoon season, the ever raising trend observed in the manufacturing cost due to increased cost of materials , transportation charges, and cost of funds in general and bank loans in particular etc pose a challenge and to what extent monetary policy alone can contain the inflationary trend is a matter to be seriously pondered? Continuance of inflation at a high level for a long time can harm the economy in the long run and the fact that inflation is the number one enemy of public cannot be ignored or forgotten. Economic Growth should bring in benefits to the masses who need food, cloth and shelter. If these essentials cannot be provided, there is no point in having any policy and the economy should not be proud of its growth.

T.V.Gopalakrishnan