Every banker worth her salt knows the Reserve Bank of India (RBI) will raise both policy rates in its quarterly review of monetary policy on Tuesday as it fights rising inflation in a $1.2 trillion (Rs56.4 trillion) economy that’s set to expand at a faster pace. It’s also fairly certain that the central bank will not tinker with commercial banks’ cash reserve ratio (CRR), or the portion of deposits banks are required to keep with RBI. This is because liquidity in the financial system is already tight and banks have been borrowing from RBI to take care of temporary asset-liability mismatches for over a month now.
The consensus seems to be that both the repo rate and the reverse repo rate will go up by 25 basis points (bps) each.
One basis point is one-hundredth of a percentage point. The repo rate is currently 5.5% and the reverse repo rate 4%.
The repo rate is the rate at which RBI infuses liquidity in the system when banks are liquidity-starved and the reverse repo rate is the rate at which the central bank drains cash when banks have too much money.
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So, in a liquidity-flush situation, the reverse repo is the policy rate, but when there is no excess money in the system and banks are borrowing from RBI, as is the case now, the repo rate is the policy rate.
The current policy rate will probably be raised to 5.75%. RBI can raise the reverse repo rate too by an identical margin to 4.25% and keep the gap between the two rates—the rate corridor, in RBI parlance—at 1.5 percentage points. But there is a possibility that the reverse repo rate is raised by a larger margin, say 50 bps, to 4.5%, to shrink the corridor to 1.25 percentage points.
What’s the need for doing that? If the corridor narrows, volatility in interest rate movements in the market will decline. It will also help keep the policy rate at a relatively higher level when liquidity returns to the system. If the reverse repo rate is 4.25%, in a liquidity-surplus situation that will be the policy rate. But if it is raised by 50 bps to 4.5%, the policy rate will be 25 bps higher in such a situation. I would think that the central bank should narrow the gap between the two policy rates unless it is absolutely sure that there won’t be excess liquidity in the system at any time soon and the repo rate is indeed the policy rate.
The wholesale price-based inflation was 10.6% in June and the April inflation data was revised significantly higher from 9.6% to 11.2%. The last time wholesale price inflation was at such a high level (it breached 12%) was between June and October 2008. At that time, the repo rate was 9%, 350 bps higher than the current level. The reverse repo rate was 6%, and the CRR was 9%, 200 bps and 300 bps higher, respectively, from the current levels. RBI started paring rates and CRR in October 2008 after the collapse of US investment bank Lehman Brothers Holdings Inc. that plunged the global financial system into an unprecedented credit crunch.
Many argue that the context of 2008 was very different; the economy was clearly growing above its potential and there were signs of overheating in certain pockets. A much higher policy rate was justifiable then, but not now, they say. This argument does not seem very convincing if one takes a close look at all macro-economic indicators. Growth in both exports and imports in the first half of 2008 and the first five months of 2010 is comparable. Industrial production growth in the first five months of 2010 is actually higher than in the first half of 2008. Bank credit growth was higher in 2008, but there is not much difference between growth in India’s gross domestic product, or GDP, between then and now. On average, the economy grew at about 8% in the first three quarters of 2008. The scene is not very different now. GDP growth was 8.6%, 6.5%and 8.6%, respectively, for the quarters ended September and December 2009 and March 2010. The Prime Minister’s economic advisory council has pegged growth for the current fiscal at 8.5%, higher than its February estimate of 8.2%. The International Monetary Fund’s forecast for India’s economic growth for 2010 is 9.4%.
RBI raised its policy rates in March and June ahead of its policy announcements. In April, this columnist wrote about shifting to a monthly or six-weekly review of monetary policy to avoid such inter-meeting actions. The central bank seems to be veering towards this idea.
Until 2005, RBI used to make two formal policy statements—in April and October—known as the slack season and busy season policies. Then RBI governor Y.V. Reddy introduced quarterly reviews in fiscal 2006. Globally, most central banks conduct a monthly policy review and a few of them, including the US Federal Reserve, six-weekly ones. The Federal Open Market Committee, the policymaking body of the Fed, holds eight meetings a year at intervals of five to eight weeks and the minutes of such meetings are released three weeks after the date of the review.
Despite the lack of adequate data to track economic activities, I am told RBI is seriously considering increasing the frequency of policy reviews to avoid inter-meeting policy announcements.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Comment at firstname.lastname@example.org