Decoding RBI's monetary policy: the what and why of it

Moneycontrol Bureau

The Reserve Bank of India on Monday decided to keep the repo rate and cash reserve ratio unchanged, disappointing both the bond and stock markets. Moneycontrol.com explains the reasons for the RBI stance and the implications of that for the economy.

What decision has the RBI taken at its monetary policy review?

It has kepT the repo rate and cash reserve ratio rate unchanged at 8% and 4.75% respectively. Repo rate is the rate at which RBI provides short term funds to banks and a key indicator of the cost of funds in the banking system. Cash reserve ratio is the portion of deposits that banks have to compulsorily keep with the RBI.

What was the market expecting?

A 25 basis point reduction in repo rate and a 25 basis point reduction in CRR

Why has the RBI chosen not to cut interest rates?

Because it feels inflation could worsen further if more funds are infused into the system by way of rate cuts. It is assumed that reduction in interest rates will lead to more demand for credit and revive growth in the economy.

How does a cut in benchmark rates help lower interest rates in the system?

Once banks' cost of funds comes down, they can pass on a part of that benefit to customers. Also, a reduction in CRR would mean banks would have more funds to lend, and this too would help lower interest rates because of extra liquidity.

Would a reduction in benchmark rates have helped reduce cost of funds in the system?

Yes and no. Because for lending rates to come down, deposit rates too should come down. And if deposit rates are reduced when inflation is already high, many savers may decide to put their money elsewhere. This will add to liquidity tightness in the system, and given the massive government borrowing, interest rates could rise further after a pause. But those supporting a rate cut argue that high interest rates hurt small and medium enterprises (SMEs) the most and will aggravate the slowdown in the economy.

But liquidity in the banking system is tight even now. How does the RBI intend to address this problem?

The RBI has said it will maintain liquidity in the system through open market operations (OMOs). This instrument is used by the RBI to both increase and reduce liquidity in the system. For instance, if there is a liquidity crunch, RBI will buy government bonds held by the banks and provide them cash. And if there is excess liquidity, RBI will issue bonds which will then be bought by banks. This will suck out excess liquidity in the system.

What else has the RBI done to improve liquidity?

To encourage banks to increase credit flow to the export sector, the RBI has increased the limit of export credit refinance from 15 per cent of outstanding export credit of banks to 50 per cent, which will potentially release additionally liquidity of over Rs 30,000 crore, equivalent to about 50 basis points reduction in the CRR.

Crude prices are falling. So is that not reason enough for the RBI to have cut interest rates?

Not really. Because as the RBI has pointed out in its policy statement, any gains from falling crude prices have been offset by the depreciation in the rupee. This means that our import bill is not really coming down. Also, if central banks in Europe and US decide to go in for another round of monetary easing, commodity prices could again shoot up.

Is the RBI trying to send a signal to the government by not reducing rates?

Definitely. RBI has been maintaining all along that unless the government reduces wasteful expenditure, it will be difficult to keep inflation in check. And unless inflation is brought under control, the RBI does not want to lower rates even if it means sacrificing growth in the short term. The government is not showing the resolve to cut fuel subsidies by hiking diesel prices. And last week, it increased minimum support price for agriculture at a time when food inflation is already quite high.

Can inflation worsen even if interest rates remain high enough to deter demand?

Much will depend on the monsoon. Poor rainfall could further drive up food inflation. And as the RBI has said in its statement, despite some signs of softening in inflation excluding food and fuel, there are serious supply bottlenecks which if not addressed quickly could push inflation higher.