RBI policy: Cut in repo rate imperative

October 23, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The Reserve Bank of India (RBI) is fixated on inflation and with that rigid mindset it is difficult to expect any liberalisation of monetary policy. But there are other parameters that have changed. Food inflation was down in September if that is any comfort. More than that, the budget deficit will be reduced with a cut in subsidies on diesel. There are also initiatives being taken on reforms. Obviously, the RBI needs to tune its policy to fit the new situation. If the RBI does change its stance, what instrument is it likely to use?

Monetary policy offers choices to address economic problems and the RBI has been using them from time to time. Two competing options are cutting the repo rate and a reduction in cash reserve ratio (CRR). The latter has been used by the RBI more frequently than most other central banks. Major central banks view the CRR as the minimum balance that commercial banks must have to be converted into cash whenever required. It is generally less than 3 percent of deposits. But CRR is not a policy instrument to manipulate liquidity.

But that is what the RBI does, even though it can achieve the same results from open market operations. With CRR, liquidity change is not directly related to the market rate of interest. It reduces the overall cost of funds and makes it possible for banks to reduce the lending rate without reducing the rate on deposits. Open market operations involve purchase and sale of securities and raise or reduce the market rate of interest while manipulating liquidity.

The repo rate is a straightforward operation. A cut in repo reduces the rate at which banks borrow from the RBI and consequently, the interest on credit and also deposits. The change in the repo rate has wider implications to the cost of money in the economy. The repo rate becomes a signal to change rates across the board.

There is enough liquidity in the system and a cut in CRR at this time would flood the banks with money they cannot use. The reduction in cost and consequently the reduction in lending rates will be too small to stimulate demand. For instance, a 1 percent cut in CRR would reduce the cost of funds to the banks by less than 0.1 percent. That would not have the desired impact. What is really called for is a substantial reduction in rates in the market. That can be achieved only by a reduction in repo rate.

The Indian economy was in a similar situation in 2008 when the world economy was amidst recession and growth in India had significantly declined. The RBI had acted fast to bring down the repo rate in quick succession in spite of prevailing inflation. That revived investment and brought the economy back on the rails. It is the cut in repo rate that has become imperative.

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