Choice is obvious

We can start expecting the RBI policy of cutting the CRR and repo rates to impact small businesses and middle-class households only once there has been a stable period of easy liquidity in money markets. Banks will give loans at lower rates and take the risk of being illiquid by giving out loans only when they are reassured that they can borrow at lower rates in the times to come. The RBI's credit policy did not do much to give banks that reassurance. Its policies have to first impact money markets before the gains from the easing of liquidity get transmitted to the rest of the system. But this is not happening so far.

Last week, immediately after the rate cuts, the call money rate was seen to be in the corridor below the repo, the rate at which banks can borrow from the RBI, of 8 per cent, and reverse repo rate, the rate at which banks lend excess funds overnight to the RBI, of 6 per cent. But on Friday they were back up again and crossed 8, the repo rate. On Monday, they went further up to an average rate of 9.3 per cent. The increase in the call money rate indicates that the liquidity situation has still not eased. As long as banks are borrowing in the overnight call money market at rates above the corridor there will be uncertainty about the liquidity situation in the coming days.

The RBI does not release the data on its forex intervention, so the extent of its rupee purchases in the forex market is unknown. However, considering the pressure on the rupee as it crossed Rs 50 and the RBI policy of preventing sharp movements in rupee volatility, it would not be surprising if the RBI undid the impact of its CRR on liquidity in the markets by buying up rupees to push it up. The choice before policy-makers is not easy. They can either have low volatility in interest rates or low volatility in the exchange rate. But they can't have both. Any attempt to reduce volatility in the exchange rate, a policy that the RBI has stood by for many years, results in sharp volatility of interest rates, as we have been seeing in recent days. This is a time when it is absolutely essential to get low, stable interest rates. If this is not done it will result in lower lending by banks, adversely impacting businesses. The benefits of low volatility in the exchange rate are not clear. Who is benefiting and how? This is not a time to repeat old policies simply because we are used to them. Another week of the RBI's watching inflation and containing volatility could easily be enough to get us a solvency crisis. The RBI needs to act proactively, cut the CRR immediately and stop buying rupees.

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