Have you, like some of our readers, been baffled at why the Reserve Bank of India seems to be using only the repo rate to combat inflation? The RBI has been trying to counter inflation by raising interest rates, increasing interest costs for borrowers and providing savers an incentive. A lower demand for loans with lower consumption due to higher savings would moderate demand, and prices.

The RBI has historically used Cash Reserve Ratio (CRR), Market Stabilisation Scheme (MSS) and the repo rate to keep tabs on inflation. However, from first half of 2010, RBI has only used the repo rate. It is only 0.75 percentage points from the peak rate witnessed in 2008. But the CRR, is still three percentage points from the September 2008 peaks. Why isn't the RBI tapping this? Let's first understand what CRR and MSS bonds are.

The CRR is a reserve banks have to keep with the RBI. The CRR ratio is now 6 per cent, i.e., for every Rs 100 of deposits a bank gets, it has to maintain Rs 6 with the RBI. This CRR doesn't earn any interest. The main aim of the ratio is to reduce liquidity in the system. Given that majority of the financial savings of households and corporates go into deposits, by increasing or decreasing the reserve RBI would be able to attain its monetary policy objective.

The MSS was introduced in 2004 to manage liquidity after there was an excessive capital flow from abroad. The capital flows were impacting rupee liquidity , which would have fuelled inflation, reducing the effectiveness of CRR hikes and other monetary tools. Under the MSS mechanism, RBI sells Government bonds. Until October 2008, MSS mopped up Rs 1.7 lakh crore from the system. The scheme wasn't compulsory but achieved RBI's objective.

But how is the current monetary tightening different from that which ended in September 2008?

Then and now

Until 2008, India's current account deficit was low and capital account excesses had to be kept under check. This time around, even as capital flows were coming in, the current account deficit was high which was compensating the for excess capital flow. These two factors neutralised exchange rate. Therefore, RBI didn't use MSS bonds this time.

Coming to CRR, it is not that RBI hasn't used it in the current monetary tightening. Till April 2010, RBI had increased the CRR requirement to 6 per cent from 4 per cent. It didn't aggressively pursue this tool as the liquidity situation had deteriorated significantly. Banks, which were sitting on excess deposits, didn't raise rates for a long time, leading to households diverting these funds to other sources. Additionally, Government and private borrowing shot up resulting in a liquidity deficit scenario. Even though the CRR wasn't hiked to previous peaks, the liquidity deficit was more than RBI's target.

A liquidity deficit situation arises when deposits aren't sufficient to fund various banking operations, prompting banks to resort to borrowing from RBI and the market to fund these operations.

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