Signal to banks

The Reserve Bank of India (RBI) announced its quarterly monetary and credit policy yesterday, in which it kept its benchmark repo and reverse repo rates unchanged, while increasing the cash reserve ratio (CRR) by 50 basis points to 7.5 per cent, effective November 10. The maintenance of the status quo on rates was generally expected, given some recent signs of moderation in economic growth and, particularly, a significant decline in the inflation rate. The RBI has retained its previous quarter's GDP growth forecast of 8.5 per cent, indicating its expectation that growth over the course of the current year will slow substantially from the first-quarter pace of 9.3 per cent. On inflation also, it has maintained its short-term outlook of 5 per cent. This combination has been widely interpreted as a comfort zone as far as the RBI is concerned, and a justification for not changing rates.

The hike in the CRR, however, sends a somewhat different signal. Since December 2006, when the RBI re-activated the CRR as a policy instrument after an interval of over two years, it has been used primarily to counteract the persistent surge of capital inflows. Prior to that move, capital inflows tended to offset policy rate hikes by bringing enough liquidity into the system to allow banks to maintain their lending rates. After that, notwithstanding the surge in inflows early in the year, rates did harden. The experience of the last few months suggests that the two instruments used together do serve the RBI's purpose. But since the equity market has continued to attract large volumes of money from abroad, particularly after the position on P-notes was clarified, many banks have shown a willingness to soften lending rates and indeed deposit rates as well. The RBI clearly feels the need to prevent this, and has chosen to curtail liquidity as a via media. There can be little doubt that the RBI believes the interest rate situation should remain stable in its growth-inflation scenario, and it has sent a clear message to the banks by hiking the CRR.

That was with reference to the domestic scenario. The global situation is, of course, more complex, with central banks around the world trying to come to grips with potential slowdowns and the declining dollar. From India's perspective, a reduction in its policy rate by the US Federal Reserve Board, either in its meeting today or the next one, will only increase liquidity in the system, some of which could potentially flow India's way and aggravate the situation. Under the circumstances, the CRR provides a way to continue to offset continuing liquidity inflows. One could read into this a position on the exchange rate as well. If the RBI continues to resist rupee appreciation, raising the CRR is one way of offsetting the consequent accumulation of foreign exchange reserves in order to maintain liquidity levels. The banking system pays the price for this in the form of interest income foregone. The other way to do it is by issuing market stabilisation bonds, the cost for which is borne by the government. There is, of course, no clear signal in the policy about what its approach to the exchange rate will be; however, the CRR hike and statements to the effect that liquidity-controlling measures would be persisted with, if necessary, suggest that the RBI will indeed attempt to at least slow down the pace of currency appreciation. However, a slow upward crawl by the rupee is likely to give overseas portfolio investors the kind of one-way currency bet that the RBI would surely want to avoid. No one should be surprised that stock prices went up after the RBI made its announcement.