Reserve Bank of India governor Y.V. Reddy has surprised at least half the market participants by leaving the policy rates untouched. And he has surprised all of them by raising banks’ cash reserve ratio (CRR), or the amount of cash that commercial banks are required to keep with the central bank, to drain excess liquidity from the financial system. With this, he has raised CRR by 175 basis points to 8.25% since April last year while the two policy rates — repo and reverse repo, or the rates at which RBI lends to banks and borrows from them, respectively — have been kept unchanged.
Why did he leave the rates unchanged and hike CRR for the second time in a fortnight? This is because CRR is a more potent monetary tool than interest rates at this juncture.
Reverse repo rate is the rate at which RBI absorbs liquidity from the system and the repo rate is the rate at which it injects liquidity. Theoretically, 6% reverse repo rate and 7.75% repo rate create the corridor for overnight rates. This means, overnight call money rates, or the rate of interest on money borrowed by commercial banks to tide over their temporary liquidity mismatches, should hover between the two rates.
However, in reality, most of the times, the overnight rates are closer to 6% than 7.75%. Too much of money has been flowing in the system and unless the liquidity is tight, RBI does not need to inject money at 7.75% (which is the repo rate). In other words, the higher end of the rate corridor can only be effective if there is liquidity scarcity in the system. Otherwise, raising the repo rate does not serve any purpose.
The other choice before Reddy was to raise the reverse repo rate, or the lower end of the rate corridor. But it has been positioned as a medium-term signal rate. This was last raised in July 2006, from 5.75% to 6%. He wants to use it only when he is absolutely sure that the rate hike is here to stay.
Since he is not convinced on this, he has chosen the best way — hiking the CRR. He could have stayed away from doing this because sales of bonds under the market stabilization scheme (MSS) can also soak up excess liquidity. But with the inflation rate above 7%, Reddy was determined to be seen doing something to anchor inflationary expectations. Under the scheme, RBI issues bonds, which are not part of the government’s annual borrowing programme, to stamp out excess liquidity. It can issue Rs2.5 trillion worth of bonds under this.
The hike in CRR — and not the interest rates — in RBI’s fight against inflation makes a few other points. One, that rising inflation is not demand-driven; it is triggered by scarcity in supply. Two, that RBI believes in the efficacy of the fiscal measures such as reduction of import duty on rice and edible oils; ban on exports of non-basmati rice and pulses, among others. Finally, it is also an indication that RBI will continue to buy dollars from the market. Bulk of the excess liquidity in the system is on account of RBI’s dollar buying. It buys dollars to stem the appreciation of the local currency. At the second stage, RBI soaks up this liquidity through MSS bonds or an increase in CRR. The problem of excess liquidity could have been tackled by allowing the rupee to appreciate against the dollar. And this would also have brought down the cost of imports and tamed inflation.
Reddy is not yet willing to allow rupee to find its own level. That’s bad news. But the fact that he has not attacked growth to cage inflation is better news.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai Bureau Chief of Mint. Please email comments to firstname.lastname@example.org.