Mr Subbarao, why not double the joy with a repo cut next week?

The Reserve Bank of India (RBI) cut the cash reserve ratio (CRR) by 75 basis points (100 bps make 1 percent) on Friday, 9 March. The larger than expected CRR cut (market was expecting 50 bps) can be attributed to four factors: 1) need to ease systemic liquidity, 2) signal a shift in monetary stance, 3) stop government bond purchases, and 4) calm market fears of an SLR (statutory liquidity ratio) cut .

It made sense for the RBI to make the cut effective from the beginning of the fresh reporting fortnight, which is 10 March. The 75 bps cut will infuse liquidity of Rs 48,000 crore into a system that is starved for cash and was borrowing over Rs 150,000 crore from the RBI on a daily basis since the second week of February 2012. Liquidity would have become tighter in mid-March due to advance tax outflows.

The 75 bps cut in CRR will be seen as a signal by the central bank that it is now shifting its stance to a pro-growth mode rather than an anti-inflationary one. The two data points that the RBI would have considered in cutting CRR by 75 bps is the third quarter GDP data that came in at a two-and-a-half year low of 6.1 percent and inflation for January printing at 6.55 percent, below RBI’s March end forecast of 7 percent.

The RBI will also put a stop to government bond purchases, which it was carrying out to infuse liquidity into the system. The central bank has bought the most amounts of bonds on record through OMOs (open market operations) this year with purchase of close to Rs 125,000 crore of bonds.

In fact, the RBI has taken up one-fourth of the government borrowing of Rs 510,000 crore this year and a continuation of backdoor deficit financing is inflationary for a fiscally profligate government. The government has overshot its deficit target of 4.6 percent by a full percentage point in fiscal 2011-12 on the back of rising subsidies.

The higher-than-expected CRR cut will also take out bond market’s fears of an SLR cut. The markets were worried that the RBI may cut SLR by a percentage point from 24 percent to 23 percent to ease the pressure on liquidity. A SLR cut will reduce demand for bonds, leading to bond yields moving up if the government is unable to bring down its borrowing.

The question now is will the central bank cut repo rates in its 15 March policy review or will it do so in its annual policy review in April 2012? The difference between March and April in terms of data points will not be much as March inflation is expected at around 6.5-7 percent levels, and this inflation number will be released in April. However, the difference a repo rate cut in March will make to money market sentiments will be high.

A 25-50 bps cut in the repo rate will bring down borrowing costs for banks in the overnight money market. The repo rate cut will also help bring down yields on CDs (certificates of deposit) that are trading at three-year highs of 10.80 percent on one-year maturity papers.

Banks have been seeing their costs of borrowing going up due to extremely tight liquidity conditions and a repo rate cut will reduce this cost.

A March repo rate cut will also help drive equity market sentiments higher and, given current global buoyancy in markets, with equities up by 10-20 percent across geographies in calendar year 2012 to date, there is a likelihood of more FII flows.

The FIIs have already pumped in over USD 6 billion (Rs 3000 crore) in equities in January and February and will continue to pump in more money on the back of expectations of monetary policy targeting economic growth. FII inflows will help ease the pressure on the rupee, which has fallen by 10 percent against the USD over the last six months.

The RBI has given a positive signal from the CRR cut and it should follow it with a repo rate cut to strengthen the signal.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com , a web site for investors.