Mumbai: Forced by a global economic turmoil to temporarily abandon its firm anti-inflation posture and a defence of the rupee that had also soaked up liquidity in recent months, the Reserve Bank of India (RBI) relaxed its monetary policy stance for the first time in five years to ease a growing pressure on the country’s banking system.

Dubbing the measure as “temporary" and “ad-hoc", the central bank cut the cash reserve ratio (CRR), or the amount of cash banks have to keep with RBI, by 50 basis points to 8.50% effective 11 October, which is expected to release about Rs20,000 crore into the banking system. One basis point is one-hundredth of a percentage point.

Liquidity management: RBI’s D. Subbarao. The central bank’s move is expected to release about Rs20,000 crore into the banking system. AP

In its statement, the central bank also said: “In view of the evolving environment of heightened uncertainty, volatility in global markets and the dangers of potential spillovers to domestic equity and currency markets, liquidity management will continue to receive priority in the hierarchy of policy objectives over the period ahead."

Industry observers were quick to point to the challenges RBI faces.

“While it is a welcome move for the banking industry, it makes inflation management more difficult," said Rupa Rege Nitsure, chief economist at Bank of Baroda. Added Devendra Nevgi, head of fixed income at Quantum Mutual Fund, in Mumbai: “It’s more of a liquidity management tool rather than any direction in the interest rates."

The latest move came on a day when India’s benchmark Sensex index of the Bombay Stock Exchange fell to a two-year low while the Indian rupee fell to a five-and-a-half-year low against the US dollar.

Meanwhile, India’s inflation has eased somewhat in recent weeks, though it remains at 11.99% after peaking at 12.63% in the week ended 9 August.

The relaxation comes after a series of six CRR hikes by RBI since April that saw the rate climb to 9% from 7.50% in January. The bank has also raised its policy rates by 125 basis points since the beginning of fiscal 2009 to rein in rising inflation.

The CRR reduction on Monday is RBI’s first since June 2003, when it was reduced by 50 basis points to 4.50%.

“There is no way banks can meet credit demand under such tight liquidity condition. Credit has been growing at 26% to meet this demand banks need funds," said Saugata Bhattacharya, an economist with Axis Bank Ltd. “This is a positive step, as this will ease some pressure on liquidity. The inter-bank lending market will also breath easy. We could see some easing of call rates."

The inter-bank market has been under pressure, as evident from the high call rates that hit a high of 17% on 28 September. On Monday, call rates ended at 11.50%.

“Call rates should ease below 8.5% after the CRR reduction kicks in. This move should see the bond market cheer, we would see the benchmark 10-year yield touch 7.90% levels," said N.S. Venkatesh, managing director and chief executive officer, IDBI Gilts Ltd.

On an average, RBI is pumping in close to Rs60,000 crore daily since mid-September.

“The RBI has been selling dollars in the market to cap the rupee from depreciating," said Neeraj Swaroop, regional chief executive (India and South Asia) at Standard Chartered Bank. “In turn, it has been sucking liquidity from the system."

“Across the world, we are seeing monetary authorities takes step to ease the liquidity pressure in the system. We could see the short-term rates (such as certificates of deposits and commercial papers) ease by about 200 basis points," said Abheek Barua, chief economist,HDFC Bank Ltd.

This is one of several other measures the central bank has taken in the recent past to ease the liquidity pressure in the system post the global credit crisis.

On 16 September, the central bank, to provide additional liquidity support to bank, had permitted banks to keep 24% of their deposits in government bonds, again as a “temporary measure". With this, RBI allowed banks to turn to it for additional liquidity support to the extent of 1% of their deposits and “seek waiver of penal interest".

Under Indian banking laws, banks are required to invest 25% of their deposits in government bonds in the form of statutory liquidity ratio. They use the excess investment in such bonds as collateral to get funds from the Indian central bank at 9%.

Since then, however, there has been a sharp deterioration in the global financial environment with the number of troubled financial institutions rising, stock markets weakening and money markets strained, RBI said in its statement.

RBI said these new developments have impacted domestic money and forex markets with a marked increase in volatility and a sharp squeeze on market liquidity as reflected in the movements in overnight interest rates and the high recourse to the liquidity adjustment facility.

Reuters contributed to this story.