English Article

With repo rate hike, RBI has done what’s Necessary

It may have surprised the markets, but the move was prudent. More hikes are likely to follow

The RBI has decided to take the bull by the horns. It has raised the repo rate by 40 basis points and the cash reserve ratio (CRR) by 50 basis points to fight inflation. We believe these simultaneous policy announcements of adjusting both the rate and quantum of liquidity is a clever ploy. Interestingly, research clearly shows that the credibility and reputation of the central bank is best recognised only when the market response to central bank liquidity operations is stronger. To that extent, the RBI seems to have killed two birds with one stone and has emerged stronger as an inflation targeting central bank. In fact, the surprise mid-term announcement by the RBI Governor today is a clear departure from past practices. It also signals the extraordinary times we live in. The most interesting aspect of the rate hike today is the continuation of the accommodative policy stance. While the markets seem to have been taken aback, we believe today’s rate hike should be seen more from a strategy perspective, rather than as a change in the monetary policy stance. We believe this is a pragmatic decision as the CRR hike may be just an attempt to build up a war chest on the liquidity front. To be more precise, liquidity inflows to the financial system could be either policy induced by the central bank (for example changes in reserves, open market operations etc) or non-policy induced (foreign exchange reserves, government cash balances, and currency in circulation). Given that nonpolicy induced liquidity inflows have been recently impacted (outflows of portfolio capital) and given the huge size of the government borrowing programme, the RBI also needs to support the market through some means. Impounding bank reserves through the CRR (Rs 87,000 crore) could give some space to the central bank to conduct open market purchases of bonds from banks and thus inject concomitant liquidity some time in the future if the need so arises. The RBI had followed a similar strategy during 2003-08 when the market stabilisation bonds were introduced, the CRR was also hiked. The CRR rate hike is thus an important tool to possibly manage G-sec yields. The markets may have missed the fine print of this move.