The Reserve Bank of India’s (RBI) decision to cut the lending rate on its marginal standing facility (MSF) by a further 50 basis points, as part of a “calibrated withdrawal” of the exceptional liquidity tightening measures taken in July, is welcome on at least three counts. First, these measures went hardly anywhere in achieving their objective: stabilising the rupee. The rupee actually fell from around Rs 60 to nearly Rs 68.5 to a dollar between mid-July and end-August. Its relative stability since then, to just under Rs 62, has been less on account of monetary tightening than other measures such as the curbs on gold imports and the concessional dollar swap facilities offered by RBI to banks for attracting Non-Resident Indian deposits and overseas borrowings.
Second, squeezing liquidity ended up raising not only the cost of short-term borrowings — which speculators were allegedly using to accumulate dollars and ‘short’ the rupee — but even rates at the long end. As yields on benchmark 10-year Government paper rose from a low of 7.11 per cent on May 24 to almost 9.5 per cent on August 19, corporate bond issuances virtually dried up. It is only after the new RBI Governor Raghuram Rajan’s moves to reverse course — though a cut in the MSF rate from 10.25 to 9.5 per cent on September 20, followed by another 50 basis points reduction on Monday — that sanity has returned to the markets. As a result, 10-year sovereign bond yields are today down to 8.5 per cent. With foreign institutional investors returning as net buyers of Indian equities on renewed ‘pro-growth’ policy signals, the rupee, too, has strengthened in the last one month.
Finally, the MSF rate cuts were essential to restore the integrity of monetary policy. It has been the stated aim of the RBI that monetary policy must be anchored to a single short-term lending rate, namely the repo. The MSF, within this framework, was envisaged only as a penal lending window. Thus, while banks could freely borrow overnight repo funds from the RBI against their excess government security holdings, they had to access the MSF window for any additional amounts and pay an extra one per cent interest. The July measures made the repo rate a virtually redundant policy tool, by restricting borrowings under it to 0.5 per cent of banks’ deposit base and simultaneously pegging the MSF rate 300 basis points higher. As a result, the MSF morphed from being a penal borrowing facility into the effective monetary policy rate instrument. Reducing the MSF-repo rate differential to 150 basis points is a correction of the policy distortions that had crept in. This differential needs to be restored to its original 100 basis points level, with the aid of another quick cut.