RBI credit policy: no new rate hikes

The Reserve Bank of India (link) did the predictable by holding on to rates at current levels in its quarterly monetary policy review. The repo rate has been retained at 7.25% and the reverse repo rate has been kept at 6.25%. Repo is when banks borrow from the RBI to meet temporary funds requirement and the reverse repo is when banks park surplus funds with the RBI.

But this does not mean that the RBI is easing its monetary policy stance. It had already taken a series of steps that have sent the cost of very short term money soaring, in its bid to take the wind out the sails of speculators in the currency market.

On July 15, a fortnight before today’s policy announcement, the RBI announced a series of unexpected measures (link). It restricted the amount that banks could borrow from RBI under the liquidity adjustment facility (LAF) at the repo rate of 7.25%. This amount was pegged at Rs 75,000 crore or 1% of the net demand and time liabilities (what the bank owes to depositors and others who have lent it money) of the system. What it did was to put a cap that banks could come to it to tide over short term funding mismatches.

The other funding window that banks have is the marginal standing facility, where banks can borrow from the RBI but at a higher rate of 8.25%, compared to the repo rate. The RBI hiked this rate to 10.25% by increasing the spread over the repo rate from 1 percentage point to 3 percentage points.

Then on July 23, the RBI took more steps (link). It said that banks can borrow only up to 0.5% of their own net demand and time liabilities under the LAF rate. This was in addition to the earlier system-related cap of 1%. It also tightened the cash reserve ratio (a portion of net demand and time liabilities that banks have to maintain with the RBI) regulations, by saying that banks now have to maintain 99% of their requirement on a daily basis, compared to 70% earlier. Banks were required to be fully compliant only by the end of the fortnight in which they reported compliance. This gave banks the flexibility to maintain it at 70% and then top it up just before the due date. RBI’s move further restricted liquidity.

These measures are harsh as they have squeezed short term liquidity in the market. Since July 15, the rupee has appreciated by 1.25% and has become less volatile too. That shows that the RBI may have succeeded in stemming the volatility and decline in the rupee versus the dollar. But it also signals that there is a long way to go, as a 1.25% appreciation is by no means a sign that it has succeeded in its objective.

That may mean that the RBI may have to stay the course till the rupee gets back to a more acceptable level. In January 2013, it traded in the range of Rs 53-54 to a dollar, and in September it traded at Rs 53-55 to a dollar. A retreat to these levels may be considered a good enough development by the RBI, assuming other factors that influence monetary policy remain steady.

The RBI has said that, under normal circumstances, the current situation—of moderating wholesale price inflation, prospects of a bumper crop and its effect on food inflation, and a slowing growth trajectory—would have been enough to continue with its monetary easing policy. But the RBI’s hand is being forced by the volatility on the foreign exchange front, and that in turn has been aggravated by foreign investors’ fears that the US economy is on the mend and that could mean that the US Federal Reserve will unwind quantitative easing (buying of bonds by the Fed that has served to provide abundant liquidity and keep interest rates low), as early as September.

The RBI has asked the government to use this time—when the RBI is being forced to take strong measures to contain forex volatility—to undertake structural reforms to bring the current account deficit under control. A current account deficit refers to a situation when a country’s imports exceed its exports. In 2012-13, India’s CAD was 4.8% of GDP while the RBI’s desirable target level is 2.5% of GDP.

Now, structural reforms take time to implement and the quality and pace of policy-making by the current government has left a lot to be desired. The onset of elections too makes it more difficult to expect reforms that may be unpopular or can become deadly ammunition in the hands of the opposition.

Therefore, it would seem that what one can hope for is the RBI’s measures to arrest volatility and help the rupee appreciate to work. They may cause collateral damage of rising short term interest rates. That could further slow India’s economic growth and that would be tragic.

The other hope for a non-RBI influence is that the US economy remains weak and proves wrong those who believe that it on the path to recovery. Key data points from the US economy, for June and July, will be watched by investors to assess if the Fed may begin the process of QE unwinding sooner than expected. In the short run, India’s fate appears linked to what is happening on the US economic front.

The stock markets were down by 111 points at 12.40pm.

Read the monetary policy document issued by the RBI here.

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