RBI Governor Raghuram Rajan has done well to reverse some of the ‘exceptional’ liquidity tightening measures introduced in July, which sought to stem the slide in the rupee. The case for doing this was strong given that the immediate threat of a tapering by the US Fed had receded and the rupee gained a measure of strength and stability. In July, the RBI had limited borrowings by banks from its 7.25 per cent-interest ‘repo’ window to 0.5 per cent of their deposits, while sharply raising rates (from 8.25 to 10.25 per cent) for borrowings beyond these from the ‘marginal standing facility’ (MSF). Banks were also asked to maintain 99 per cent of their fortnightly average cash reserve requirements (CRR) on a daily basis. These measures resulted in a sharp spike in the cost of funds for banks and made short-term money expensive for corporate India.
What the RBI has now done is to cut the MSF rate to 9.5 per cent and marginally raise the repo rate to 7.5 per cent. The cut in MSF rates should bring a measure of relief to banks, whose overall borrowing costs from the RBI will now decline by about 30 basis points. Together with the reduction in the daily CRR to 95 per cent of the fortnightly average requirement, Rajan has signalled a rollback of the desperate tightening steps taken in July, which in any case failed to achieve the stated objective of “addressing exchange rate volatility”. What it did was to raise interest rates in the market and worsen investment sentiment. Moreover, it made the repo rate a virtually redundant benchmark, contrary to the stated aim of anchoring monetary policy with a single central bank lending rate.
By reducing the MSF rate and promising to shrink the gap between it and the repo rate to the earlier 100 basis points level, Rajan has signalled his intention to correct the policy distortions that had crept in over the last few months. Ideally, he should have refrained from raising the repo rate, which has sent mixed signals. But his hand was constrained somewhat by the latest inflation numbers and by his own decision to ease lending rates to banks with the reduced MSF. With the kharif crop due to arrive in the markets and the rupee showing signs of settling down, the next October-end quarterly monetary policy review may be the right time to fully assess the new RBI Governor’s approach — particularly on how he tackles the perennial growth versus inflation issue. Will he go in for a repo rate cut then? It’s hard to say. But he would do well to walk his pro-growth talk by lowering the MSF rate by 100 basis points before the next review.