The Monday late evening Reserve Bank of India (RBI) action is nothing but a rate hike by stealth, that too by a whopping 3 percentage points, ostensibly to iron out volatility in the currency market. The rupee hit its lifetime low of 61.21 per dollar on 8 July. Since then, it has recovered (it closed at 59.89 per dollar on Monday), but RBI is not convinced about the recovery in an extremely thin market.

While this looks like a knee-jerk reaction as RBI had already banned banks from trading in currency, the not-so-bad news is that the tightening of liquidity and the resultant hike in interest rate could be temporary.

Traditionally, RBI hikes its repo rate, or the rate at which it lends money to banks, to take care of their temporary asset-liability mismatches to signal a tight money policy. Once the repo rate is hiked, automatically, three other rates rise as they are anchored to the repo rate. They are reverse repo rate, or the rate at which RBI sucks out liquidity from banks, the bank rate, and the marginal standing facility rate (MSF).

Till Monday, the repo rate was 7.25%, the reverse repo rate 6.25% and MSF and bank rate 8.25%.

RBI has now broken the chain; it has left the repo and reverse repo rate untouched, but hiked MSF and bank rate to 10.25%. And, to make this effective, it has capped its daily liquidity support to banks.

When liquidity is tight in the banking system, the repo rate is the policy rate. In a liquidity surplus-situation, when banks rush to RBI to park extra money, the reverse repo rate is the policy rate.

MSF becomes effective only when the liquidity in the system is extra tight—the banks want to borrow from RBI but they cannot unless they pay a higher rate.

Typically, the overnight call rate moves in the corridor between the repo and the reverse repo rate. By capping the banks’ access to the repo window at 75,000 crore, RBI is making sure that the call rate rises to the MSF rate or 10.25%. This way, without tinkering with the repo rate, RBI has taken up the market rate.

Now on, the interest rate will remain stable till the daily liquidity deficit in the system is 75,000 crore and once it crosses this threshold, the call rate will shoot up to 10.25%.

It’s pretty evident that RBI wants the rate to go up by tightening liquidity through sale of government bonds.

To start with, it will sell government bonds worth 12,000 crore on 18 July. Presumably, this will be the beginning of a series of such bond sales. In past few years, RBI has been buying government bonds through the so-called open market operations (OMO) to infuse liquidity in the system. This is the first instance of RBI selling bonds through OMO in a long time.

During the previous governor Y.V. Reddy’s regime, which ended in September 2008, RBI used to sell bonds under a special scheme called market stabilization scheme (MSS) to soak up excess liquidity from the system. The liquidity was a result of foreign money flow. Now the context is very different. Foreign investors are pulling out from the debt market, yet RBI plans to drain money as it wants liquidity to be extra tight so that no bank can use rupee resources to punt on the currency.

Till Monday afternoon, the debate had been whether the rate cut cycle was over because of a depreciating currency and inflation inching up. Will the cycle reverse soon with RBI hiking interest rates after tightening liquidity? The latest measures do not conclusively say so and it does appear that they are temporary in nature.

The RBI release said the central bank will continue to closely monitor the markets, the liquidity situation and the macroeconomic developments and “will take such other measures as may be necessary, consistent with the growth-inflation dynamics and macroeconomic stability".

Indeed, inflation is inching up but slowing growth is a bigger concern in Asia’s third largest economy and RBI cannot afford to be insensitive to that. Once stability returns to the currency market, the central bank will have to reverse these measures and even cut the rate if it wants to bring back growth momentum in Indian economy. The question is : How long will it take? A few weeks won’t be an issue, but if it takes months, these measures will surely deal a blow to the growth story. Meanwhile, RBI’s quarterly review on 30 July—governor D. Subbarao’s last policy if he does not get an extension—may turn out to be a non-event. A rate cut is ruled out and RBI may not opt for a rate hike either, fearing the impact on growth.

Banker’s Trust Realtime is a frequent blog by Tamal Bandyopadhyay, who writes a popular weekly column Banker’s Trust.

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