Facing the tough task of bolstering the rupee's valuation, the Reserve Bank of India (RBI) surprised the market on July 15 with multiple measures. It announced two percentage points increase in the interest rate
for overnight borrowing against approved government securities by Indian banks under the marginal standing facility. With the rate pegged at three percentage points above the repo rate, it now stands at 10.25%.
The marginal standing facility, where the lending rate is high, is used by banks when extreme liquidity crisis in the system prevents them from meeting the minimum mandated government securities holding.
Apart from increasing the inter-bank lending rate, the RBI has also capped
the daily support to banks under the central bank's liquidity adjustment facility (LAF) at Rs 75,000 crore.
"The overall allocation of funds under the LAF will be limited to 1% of the net demand and time liabilities of the banking system, reckoned as Rs 75,000 crore for this purpose," the RBI said in a statement.
This means the overnight lending rate will shoot up to 10.25% when the daily liquidity shortage in the Indian banking system breaches the cap.
These moves have been taken to tighten liquidity
and support the rupee, which has been depreciating of late. On 8 July 2013, the rupee was trading at its all time low of Rs 61 against the US dollar.
Any sudden impact of the measures on the lending and borrowing rates is unlikely. State Bank of India, the country's largest bank, said the move does not require any adjustment in lending rates because the position is expected to stabilise shortly as these measures are designed to curb speculation in the market and are not indicative of any systemic problem.
The measures have resulted in some collateral damage - a spike in short-term bond rates and firming up of the long yield curve.
"The 10-year government securities yield moved up from 7.60% to 8.10% in a day, which has been unprecedented. This dislocation may represent a buying opportunity for investors with a medium term outlook," says R Sivakumar, head (fixed income), Axis Mutual Fund.
There are some fears of more liquidity tightening measures at the upcoming policy meet, but not all experts think so.
"The RBI is unlikely to do so to avoid indicating the start of a tightening cycle as it considers the current currency weakness as temporary," says Dilip Shahani, head of Asia research at HSBC.
The RBI had also put up Rs 12,000 crore of government securities for sale through an auction on July 18. However, it managed to sell less than one-fifth of the target, as investors demanded higher interest rates.