The RBI chose to hike the cash reserve ratio (CRR) by another 25 basis points in its credit policy announcement on Tuesday. This is expected to suck out an additional Rs 8,000 crore of liquidity from the Indian economy. The central bank kept the repo and the reverse repo rates unchanged. Since the repo window has hardly been used by banks in recent times, raising it would not have been an effective instrument to reduce credit growth. An increase in the reverse repo from 6% to above the bank rate, currently also at 6%, would also have been pointless. Any interest rate hike would have increased the interest rate differential further. This has already been pulling in huge amounts of capital since the US Fed started cutting interest rates in July 2007.

On April 17, RBI had already announced an unscheduled CRR hike from 7.5% to 8% in two stages. This has been upped to 8.25%. RBI?s macroeconomic assessment says that reserve money growth was 31% last year. This growth has been due to the high growth in RBI?s foreign exchange assets resulting from its intervention in the forex market. In other words, the credit policy and the earlier CRR hikes are attempts to soak up the liquidity gush caused by RBI?s forex intervention policy.

It is unfortunate that banks, and ultimately their customers, have to bear the brunt of RBI?s sterilisation efforts. Had it not been so busy keeping the rupee weak to satisfy export lobbies, today banks and their customers would not have been forced to pay this tax on the banking system. A higher CRR forces banks to hold more money at unrenumerative rates with the RBI. This would mean that their net margins are higher and customers earn low interest rates on deposits, while they pay high interest rates on borrowings.

On a broader note, RBI disappoints as usual in failing to make progress on improving transparency or communication with the market. A two- to four-page concise policy statement that focuses clearly on its challenges, difficulties, options and choices exercised would have been welcome. Instead, we have got a massive 79-page, long-winded report that misses the wood for the trees.?Now, even after the credit policy announcement, the market is still left no wiser about what the RBI wishes to do next.

In RBI?s statement, Governor Reddy fails to clearly point out the conflicting objectives on inflation, growth and rupee management, and instead, appears to suggest that all these are being effectively dealt with. The huge increase in liquidity that has resulted from RBI?s intervention in forex markets in its attempt to peg the rupee to a weakening dollar are hidden away in terms like ?sizable accretions? to its forex assets. The report does not discuss why the net issuance of MSS bonds of Rs 1,05,691 crore during 2007-08 has proved to be inadequate in containing liquidity growth. It fails to clearly articulate why, instead of more open market operations, it has chosen to hike the CRR. While it discusses global liquidity conditions at length, there is no clarity on the impact it has had on interest differentials with India, on RBI?s responses in terms of capital controls, on the effectiveness of ECB/PN restrictions and other controls. In other words, there is excessive detail on things that do not matter, and little clear discussion on issues that do. This is consistent with RBI?s past policy of not being transparent or giving clear signals to the market. It evidently thinks that monetary policy is most effective when it surprises the market.

So, what might lie ahead? The CRR hikes indicate that RBI is finding it more and more difficult to sterilise its forex intervention using the preferred instrument of MSS bonds. In such a situation, any central bank would prefer to pump less liquidity into the economy. However, this will necessarily be a political decision. If the export lobby remains politically influential, we might see continued intervention in the forex market and more of the current difficulties. This could mean more CRR hikes for banks. However, if electoral politics comes to dominate the discourse, RBI may be able to step away from the forex market. While the direct impact of a rupee appreciation on prices may be limited to 1 or 2 percentage points, not having to buy up dollars will make RBI?s job of managing liquidity easier. Since the main source of liquidity is its forex intervention, the central bank would not be spending all its energy trying to mop up liquidity.

For almost five years, RBI appears to be hoping that the problem would go away on its own. The policy of sterilised intervention that it has followed for more than five years now suggests that it sees capital inflows as a short-term phenomenon. This policy is showing cracks. Unfortunately, this credit policy has been another lost opportunity.

?Ila Patnaik is senior fellow at National Institute of Public Finance & Policy. These are her personal views