Column: Reverse liquidity tightening

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SummaryLower pressure on EM currencies offers a window to correct mistakes made in the last two months

Reserve Bank of India took a number of steps to tighten liquidity and raise rates in mid-July. As a consequence of these steps interest rates today are up to 400 basis points higher than they were in the beginning of July. While this rate hike is reminiscent of the rate hike of 200 basis points by Bimal Jalan on January 16, 1998, when he stepped in to defend the rupee in the Asian crisis, such a steep policy rate hike has never been done before. Moreover, it was implemented through non-transparent and quantitative measures that have damaged the operating procedure of monetary policy.

While some other emerging markets (EMs) have also defended their currencies with interest rate hikes, it has not been so brutal. It has also been done primarily by raising policy rates and not by breaking down the operating framework of monetary policy.

In its credit policy announcement RBI must first and foremost reverse these steps and restore the operating procedure of monetary policy. Only then can it discuss the stance of monetary policy. No monetary policy designed to manage expectations can deliver any meaningful objectives if rates are raised so sharply and so suddenly. The tightening was supposed to be temporary and so reversing the measures will not damage RBI's reputation for consistency. The current phase of lower pressure on EM currencies offers a window to correct the policy mistakes made in the last two months.

Mid-summer tightening

On July 15, Reserve Bank put in place measures in response to the pressure on the rupee to depreciate. They included raising the MSF rate by 200 bps to 10.25%, restricting the overall access by way of repos under the liquidity adjusted facility (LAF) to R750 billion and undertaking open market sales of government securities of R25 billion on July 18.

On July 23, RBI modified the liquidity tightening measures by regulating access to LAF by way of repos at each individual bank level and restricting it to 0.5% of the bank’s own NDTL. This measure came into effect from July 24, 2013. The cash reserve ratio (CRR), which banks have to maintain on

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