Upward spiral

Wholesale price inflation has risen to 6.12 per cent in the 12-months to January 6, far above the RBI’s upper limit of 5.5 per cent. Seen together with the 14.4 per cent rise in industrial production in November and the 30 per cent increase in bank credit, most bankers expect the RBI to raise the repo rate at its January 31 meeting on monetary policy. That could lead to another round of interest rate increases.

At the same time, the Centre is removing the floor on the SLR requirement. This will enable the RBI to allow banks access to liquidity, if needed. Won’t a cut in the SLR at this juncture be contradictory to the RBI’s tightening policy? Well, the SLR is actually a government draft on bank resources, which means it influences the allocation of resources, not its price. If the SLR floor is lowered, that would mean less resources automatically earmarked for the government. The government would then have to pay a higher price if it wants to borrow more. That is why yields on government bonds spiked up sharply when the news was announced. (The other reason was that some banks hold government bonds in excess of the SLR requirements, which they could dump in the market if the floor was lowered, thereby leading to a price crash and a jump in yields.)

On the other hand, with a lower SLR, banks need not invest so much in government securities, which means that more money can be lent to companies or to the retail sector.

That could hold down interest rates on these loans. And that, precisely, is the signal that the RBI wants to avoid giving. In the longer-term, however, it shouldn’t really matter to the RBI whether the money is being borrowed by the government or by the corporate sector.

In fact, a lower SLR should be a blessing for the RBI. That’s because, with the rise in deposits, banks have no alternative currently but to buy government securities in order to meet their SLR requirements. With fiscal deficits coming down, the supply of government paper is not increasing to that extent.

The upshot is that the demand for SLR securities is higher than the supply, which leads to a downward pressure on yields. In short, it is this effect that has kept long-term yields down despite the RBI increasing the short-term policy rate. The result has been a flatter yield curve, which has been negating the tightening that the RBI has been trying to achieve.

There are two factors that may go against a rate hike. One is that the ABN Amro Purchasing Managers’ Index (PMI), which is supposed to be a coincident indicator of the state of the manufacturing sector, has been decelerating. It remains to be seen, however, whether the IIP numbers will mirror the PMI.

The other factor is that FII inflows are now a trickle and stocks have moved up on buying by domestic investors. If the drought in FII flows continues, that will automatically mean lower liquidity. At the same time, however, the slack in FII inflows may be taken up by higher FDI or by more external borrowing. For all these reasons, the RBI is likely to tighten further on January 31. Bond yields are already discounting that. The stock market, however, seems blissfully unconcerned.