When the Reserve Bank of India (RBI) raised its policy rates as well as the cash reserve ratio (CRR), the portion of deposits that commercial banks need to keep with RBI, by a quarter of a percentage point each in its annual monetary policy in April, many analysts found the central bank too soft in its approach. They predicted another round of tightening ahead of its July review of policy as the economy has been on a firm recovery path, riding a surge in demand, amid signs of rising asset prices. RBI governor D. Subbarao also kept the door open for such action by saying the central bank is prepared to respond “appropriately, swiftly and effectively" to combat inflationary pressures.

The European debt crisis seems to have changed the scenario and at this point, nobody is talking about a rate hike in June. Some of them have even started saying RBI should maintain status quo even in July when it reviews monetary policy. None of the global central banks has raised policy rates in recent months since the debt crisis broke out, including the Reserve Bank of Australia, the most aggressive policy tightener among them. After hiking the rate for three successive months, the Australian central bank board last week decided to hold the rate steady at 4.5%. Since October 2009, it has raised the rate by 150 basis points. One basis point is one-hundredth of a percentage point.

Meanwhile, RBI is busy tackling domestic developments. In the last week of May, it took a couple of proactive steps to ease liquidity pressure that was seen building up on account of two factors—advance tax outflow of around Rs40,000 crore and telecom firms raising money from banks after successfully bidding for third-generation (3G) spectrum. Indian corporations pay advance income tax every quarter on their projected profits, sucking out liquidity from the system. This time around, there was more pressure on the system as the successful bidders for 3G spectrum had to pay Rs68,000 crore to the government and the banks’ share in this was around Rs45,000 crore. There were fears that the combination of demand from telecom firms and advance tax outflow would cripple the banking system. So the RBI opened a second window to offer liquidity to the banks at 5.25%.

Also Read Tamal Bandyopadhyay’s earlier columns

RBI injects liquidity into the system at the repo rate and sucks out liquidity at the reverse repo rate, which is currently 3.75%. Till 2 July, it will keep its repo window open twice—once in the morning and once in the afternoon. Secondly, it has also allowed commercial banks to borrow from the central bank up to 50 basis points of their deposit base. The liquidity thus generated, around Rs22,500 crore, can be used to meet credit demand.

This, in effect, amounts to a cut in banks’ mandatory investment in government bonds, known as the statutory liquidity ratio, or SLR. Under current norms, banks are required to use 25% of their deposit portfolio to buy government bonds. Till 2 July, they can maintain 24.5% investment in government bonds. The use of SLR as a tool to manage liquidity is relatively new for RBI. In November 2008, it cut banks’ SLR to help them tide over an acute liquidity crunch following the collapse of US investment bank Lehman Brothers Holdings Inc. It was restored by October 2009 as liquidity improved.

There are many ways to manage liquidity. The most conventional way is the use of CRR, currently pegged at 6%. Once the CRR is hiked, banks need to keep more money with RBI. The cost of a hike in CRR is borne by the banks as they do not get any interest for the money kept with the central bank. While CRR absorbs money for a relatively longer term (as RBI doesn’t want to tinker with CRR too often), repo and reverse repo are temporary measures of managing liquidity. When RBI sucks out liquidity through the reverse repo window, it bears the cost of draining money.

There is yet another way of sucking out liquidity—the market stabilization scheme, or MSS, bonds. These bonds drain excess money from the system but they are not part of the government’s annual borrowing programme that raises money to bridge its fiscal deficit. The MSS bonds are kept with RBI in a special account and government bears the cost of this liquidity absorption exercise. When the system needs money, these bonds are liquidated.

The use of SLR as a monetary tool shows the Indian central bank’s flexibility and innovativeness. Besides, since banks typically invest more than 25% of their deposits in government bonds, for all practical purpose a cut in SLR does not affect the government’s money-raising programme.

Should RBI maintain status quo in its July policy? It’s too early to take a call on this as nobody is sure about the depth of the debt crisis in Europe and its impact on the world economy. But looking at the food and fuel price inflation in India, one would think monetary tightening is on the cards. The wholesale price-based inflation was 9.59% in April after hitting 10.6% in February, the highest since October 2008, but neither the government nor RBI seems to be doing much to fight inflation. The central bank has hiked its policy rate as well as CRR twice in small doses since March to make money more expensive, but they do not seem to have been enough to fight inflation that remains way above RBI’s comfort level. If the monsoon is on track, RBI has very little choice but to tighten its policy in July, unless the European debt crisis intensifies dramatically.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at bankerstrust@livemint.com