What's troubling RBI?

RBI governor Y.V. Reddy is playing hardball. With inflation hovering in the central bank's comfort zone of 4-4.5 per cent, there seemed to be a consensus among bankers that he would ease up on tightening monetary policy. Some, like ICICI Bank CEO K.V. Kamath, had expected rates to soften. But in RBI's quarterly review of monetary policy announced on July 31, Reddy sprang a surprise. Though he left the key Bank Rate and repo rates unchanged, he once again hiked the cash reserve ratio (CRR) by another 50 basis points to 7 per cent and removed the Rs 3,000-crore cap on daily reverse repos under RBI's liquidity adjustment facility.

This is the fourth time in eight months that the central bank has raised the CRR, in all by 200 basis points. The objective, it says, is to maintain appropriate liquidity. The latest hike will drain Rs 16,000 crore out of the banking system. What will also help in mopping up excess liquidity is the decision to lift the cap on reverse repos.

So, what will be the fallout of rbi's measures this time? The good news is that the CRR hike is unlikely to translate into higher interest rates. There is an estimated Rs 40,000-crore excess liquidity in the system. But, points out Subir Gokarn, Chief Economist, CRISIL: "It will certainly put an end to the banking sector's plans of lowering lending rates as some banks had already started to do. That is one of the objectives of taking these measures."

With their net interest margins taking a hit (they do not get any interest on CRR deposits with RBI), banks will be forced to lower deposit rates. Some, like the Bank of India and Bank of Baroda, have already lowered their rates on one-year deposits by 50 basis points to 9 per cent. For the middle class, which has already been hit by the steady rise in interest rates on home and consumer loans over the last year, this is a double whammy. For one, the CRR hike almost certainly rules out any immediate softening of interest rates and then, they will get lower returns on their bank deposits. Says Gokarn: "That's a trade-off that RBI had to make. The larger good of controlling inflation and ensuring macro-economic stability might well be worth the cost of taking these measures."

The central bank is keen on ensuring that excess liquidity in the banking system does not push the inflation rate upwards once again. Says T.K. Bhaumik, Chief Economist, Reliance Industries: "RBI is facing a dilemma. You have high growth rates on the one hand and the central bank obviously doesn't want to disturb this momentum. On the other hand, inflationary pressures remain due to higher oil prices." This probably explains why it has kept interest rates untouched and opted for a CRR hike.

Then, there is the problem of the appreciating rupee affecting exports. Analysts feel that RBI is likely to intervene actively in the forex market in the days ahead to keep the rupee stable at 40-40.50 levels to give some respite to exporters. This will result in fresh infusion of liquidity into the system as the central bank releases more rupees to mop up dollars. Says Bhaumik: "The CRR hike is a pre-emptive measure to suck some of the excess liquidity from the system before it intervenes to prop up the rupee."

The central bank's initiatives then seem to be based on a three-pronged strategy-growth should not be hit, cost of money should not go up and yet liquidity must be managed. Whether it hits the bullseye with its gameplan remains to be seen.