4 possible RBI steps today and what it means for you

Reserve Bank of India Governor Raghuram Rajan is presenting his second monetary policy review today. Many things have changed over the last six weeks after his first review. The most important is the rupee’s movement against the dollar. The currency has pulled back about 10 percent from its life low of 68.80 against the greenback.The stabilisation is not only because of Rajan’s steps. The US Fed’s decision to defer tapering of bond purchase has also contributed to the decision.

However, one worry that just aggravated during the period for the RBI is inflation. The inflation rate has remained at the elevated levels and is not showing any signs of relenting yet. One of the key reasons for the high inflation is the prices of onions, which have hit Rs 90 a kg at the retail level. The wide expectation is that the RBI will increase repo rate today and cut marginal standing facility rate.

Here are the steps the RBI is likely to take and their impact:

[caption id=“attachment_1195439” align=“alignright” width=“380”] Reserve Bank of India Governor Raghuram Rajan is presenting his second monetary policy review today. AP photo[/caption]

1) Raise policy rate: The RBI is expected to increase its repo rate by 25 basis points (bps) to 7.75 percent, according to 29 of 41 economists polled by Reuters. Repo rate is the rate at which banks borrow funds from the RBI. This is the policy rate of the central bank and determines the interest rate in the economy.

Food price inflation is at a 38-month high of 18.4 percent in September. It could spread to generalised inflation expectations already high. “Both WPI (wholesale price index) and CPI (consumer price index) inflation may stay range-bound around the current levels that remain above comfort levels,” the RBI said in its macro-economic report. So does the RBI expect the inflation may even rise above the current levels? It seems so.

Higher interest rate is an important tool with the RBI to control inflation. So a policy rate increase is all but given. The only question is whether it is going to be 25 bps or 50 bps. If it is 25 bps, expect Rajan to do another one in the next review in December. Industry will, definitely, cry foul. But then, the RBI’s raison detre is not just boosting the corporate houses. It has to take care of those at the bottom, who will be the worst hit by spiralling inflation.

2) Cut MSF rate: Marginal standing facility is a daily window through which banks access funds in urgency but at a higher rate than the repo rate. As of now, the MSF rate is at 9 percent, 150 bps higher than the repo rate. This facility has been of use to banks since the RBI had narrowed the repo window to 0.5 percent of NDTL in its fight to save the rupee. NDTL is net demand and time liabilities of banks. In other words, bank deposits.

Even the largest lender, the State Bank of India, which is usually flush with liquidity was forced to borrow MSF money after the central squeezed the repo window. The RBI is likely to cut this rate by 25 bps to 8.75 percent. This, along with a 25 bps hike in repo rate, would normalise the spread between MSF-repo rates at 100 bps. As part of its rupee defence, the RBI had earlier increased this differential to 200 bps by hiking the MSF rate. The increase in MSF rate pushed up the short-term rates in the economy, which hurt the business sentiment.

A cut in this rate should help businesses as their short-term borrowing cost will come down. This will serve to balance the bearishness stemming from the repo rate hike. But definitely, industry will not be satisfied. As always, they would bay for largest peace of the cake. Banks would heave a sigh of relief as their cost of funds will come down, though marginally.

3) Loosen liquidity: Will the RBI loosen its grip on liquidity by widening the repo window for banks? The window was squeezed to curb speculation on the currency. Some players were accessing cheap funds from this window and taking advantage of the arbitrage opportunity in the forex market. At the peak of its volatility, the rupee forwards offered good arbitrage between unregulated overseas forex market and domestic market.

So the RBI cut the funds available through this window to 0.5 percent of bank deposits. Now that the rupee has clawed back, will the RBI be comfortable to increase this to 0.75 percent of deposits or may be 1 percent? That will increase the liquidity in the system, especially during the festival season, when cash circulation peaks. Nobody has a clue on this yet.

4) The rupee defence: Now the big question: Will the RBI draw back other rupee defence steps? One of the steps was the special swap window it had opened for the oil companies, which on a daily basis buy about $400 million daily from the forex market. By opening a swap window, the bank had taken away that much of dollar demand. This step had helped the rupee big time. Is the rupee ready to take this kind of pressure?

Consider this: Governor Rajan’s recent statement that the RBI is considering closing this window had pulled down the rupee against the dollar. The central bank later clarified that any tapering would be done in a calibrated manner and the window was very much open. This helped the rupee cut the losses. Given the sensitivity of the matter, the RBI will not withdraw this measure all of a sudden. It will be gradual. All eyes are on whether it will make announcement on this today.

The RBI yesterday said in the macro-economic report that it had amassed about $11 billion through the swap facilities that it offer to oil companies and banks. The central bank offers a swap facility at cheaper rate to banks to encourage them get forex deposits.