Doing away with its calibrated baby steps approach, the Reserve Bank of India has gone for a steep 50 basis points hike in repo rate to rein in the galloping inflation, which has been ruling much above the RBI's comfort zone of 6 per cent. Though the central bank expects inflation to remain at the elevated level of 9 per cent during the first half of the current fiscal, its objective is to bring it down to 6 per cent by March 2012.

In an interview to Business Line , the RBI Governor, Dr D. Subbarao, explained the central bank's policy stance:

So you have done away with the baby steps?

Well, in a manner of speaking, if you define a baby step as 25 basis points, we've moved beyond that.

Would you think you need any back-up from Delhi in terms of fiscal measures to bring down the inflation to the desired level?

For monetary policy to work, the fiscal system has to be appropriately positioned. And we were quite happy when there was a rollback of the fiscal deficit in the Budget but now it looks uncertain about what might happen to the fisc given the high oil prices and the uncertainty about when and how much they might pass on to customers.

Do you think the 50 basis point hike will result in a liquidity crunch?

I don't believe so, because we will manage liquidity as we have done over the last one year. We said that for monetary policy to be efficient and for monetary transmission to work, the system must be slightly in deficit. We have also indicated that our zone is plus/minus one per cent of NDTL. So should there be a liquidity crunch like we experienced last year we will take measures necessary to manage that.

You have lowered the growth projection to 8 per cent. With demand for capital goods already slowing, do you think even 8 per cent would be achievable?

Yes. That is our estimate and we said around 8 per cent. So there could be a margin of error around that. I wouldn't say margin of error but a margin of actual outcome around that. But that is our estimate as of today.

Why did you increase the savings deposit rate when you are thinking of deregulating it altogether?

Well, we put out a paper discussing the pros and cons of deregulation. And we need to get feedback on that. You know I've consulted a lot of people, bankers, analysts, economists, journalists on this, and there are weighty issues around this. On the one hand, we need to give a remunerative rate of interest to middle-class and lower middle-class people who depend on this. On the other hand, we want to make sure that very low income people and poor people are not entirely priced out of the banking system because the savings bank deposits become too complex for them. So, there are a number of uncertainties and variables around this. We thought that if we have a debate on this, we will be better informed.

Why raise it in the interim?

Right. It was driven by a number of considerations. First, other deposit rates have gone up but savings rate has remained frozen at 3.5 per cent for the last several years. Second, when inflation is high, there is real income loss to people who put money in savings bank accounts. We thought we should compensate them at least partly.

You have gone for a single rate. Is the system more suitable for a country like India?

I believe most advanced countries have a single rate. They also have the discount rate, which forms the corridor, but the signalling policy rate is a single rate.

Well, (it is suitable) for a maturing economy. That's the way forward. We've moved one more step forward. Remember, we had selective credit controls and a number of other controls. We came to policy rates, we came to LAF corridor. Now, we've given up one independent variable. I believe this is the way forward.

Is there any reason for the timing for capping banks' investments in liquid mutual fund schemes? The circular movement of money between banks and mutual funds has been happening for some time. So, was there any reason to believe that it was potentially reaching a dangerous level?

Well, I don't believe that. I don't think that's correct. We've been thinking about it for a long time and we‘ve talked to banks, talked to money market participants and we've done it now. This is a long-term systemic issue, and should not be seen in the context of the current situation.

Has it been done to prevent bank funds from being diverted?

Yes, as you said this is circular movement. Banks put money in mutual funds and mutual funds come and put money back in the banks. That's not good for stability reasons because if there are sudden calls on that money, mutual funds should be able to deliver that. And that will be imperilled if the circularity continues to build on itself. There was some tax advantage; I think part of that is gone with the Budget, right?

You have introduced a new liquidity facility- MSF. How will it align with overnight call rate?

The expectation is that the call rate will be around the repo rate. That's the target. This exceptional marginal standing facility (EMSF), meant to be exceptional at a rate of one per cent above the repo rate which banks will access once they have exhausted all other avenues for overnight money, market repo CBLO etc. That is why it is meant to be exceptional.

Will it help manage volatility?

Well, the idea is to manage volatility in the money market and the idea in moving to a single policy rate is to signal RBI's policy intentions more accurately.

It was expected that the bank licensing policy would also be announced with the credit policy?

Well, we're discussing with the government. We've prepared draft policy after consultation, after the feedback, reflecting all the feed back, reflecting all the views that we got. And there are some issues to be settled with the government and I am hopeful that they will be resolved soon.

Can we expect it within a month?

I cannot put a time frame on that because you know, there are other actors involved in this. To move forward on new bank licences, we also need to get the amendments to the Banking Regulation Act through. That I believe is before the Standing Committee at this moment.

Only after that we will see?

Well, the process can start only after that as the rules of the game have to be clear.

What about the policy on foreign banks?

That's also pending with the government. We have resolved most of the issues; there are some like those pertaining to tax implications of branches and converting into subsidiaries. The Government has to apply its mind and give a clarification so that everyone is aware again of what the rules of the game are.

So, that will also take some time.

Well, that will take some time. Again, you know, if it was entirely within the RBI control, I could give an indication. But, I cannot put a time frame on things beyond RBI's control.