A balancing act

The Reserve Bank of India’s lack of action on its policy rates, in the mid-quarter review announced on Thursday, was  well anticipated. The RBI had in its quarterly monetary policy review last month had given a hint that it would not aggressively pursue policy action in the near future. Accordingly it has left untouched all the main three tools of monetary policy available to it — the repo rate, the reverse repo rate and the cash reserve ratio for banks. But the review is important for what it did on the liquidity front and for what it feels about inflation in the coming months. The bank has seen a liquidity shortage in the system, accentuated by the movement of funds from the market to the government through big disinvestment IPOs and 3G and broadband auctions. Last month’s enhancement of the liquidity adjustment facility (LAF) was not very effective and the bank decided to act now.

It has resorted to two measures to ease the situation, which it feels could constrain the banks’ ability to expand their balance sheets. One is an open market operation to purchase government securities from the banks which will release about Rs 48,000 crore into the system. The other is a permanent reduction in the statutory liquidity ratio (SLR) by one percentage point to 24 per cent. This would help the banks to use only a smaller part of the deposits to buy government bonds. The government therefore may have to make its bonds more attractive, with higher interest rates. However, even with these measures it may take some time for the liquidity gap to be bridged.

The RBI is worried about inflation which continues to be a major threat to domestic budgets and the health of the economy. The bank’s growth projections are likely to be exceeded but hopes about inflation control may be belied. The target of 5.5 per cent by March next year does not seem to be achievable, though the rate has come down from two digits to about 8 per cent. Food inflation is still very high. Domestic demand is rising, as also global commodity prices including, most importantly, petroleum prices. Many of the factors that now contribute to inflation are beyond the RBI’s power to control. But it may have to take whatever action it can, like a hike in interest rates, in the next policy review.

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