RBI Governor Raghuram Rajan. PHOTO: AP
Reserve Bank of India (RBI) Governor Raghuram Rajan is widely expected to make a return to normal monetary policy operations on Tuesday when he announces the second-quarter policy review.
Rajan, in his second policy review since taking over as the RBI chief, is likely to make the repo rate the effective policy rate that decides lending rates in the economy.
Here's how he will likely do it. Rajan is expected to raise the repo rate
, the RBI's main lending rate, to 7.75 per cent from 7.50 per cent. Simultaneously, he will likely reduce the Marginal Standing Facility (MSF) rate to 8.75 per cent from 9 per cent.
MSF is a short-term borrowing facility
for banks over and above the Liquidity Adjustment Facility.
The repo rate hike is warranted because of inflationary pressures in the economy. The wholesale price index-based inflation accelerated to 6.46 per cent in September from 6.1 per cent in August. This is outside the RBI's comfort zone of 5-5.5 per cent. The case for a reduction in the MSF rate is backed by the normalcy in the foreign exchange market. FROM THE MAGAZINE:Rajan needs to walk a long way before he can pare rates
These twin policy changes will bridge the difference between the repo and MSF rates at 100 basis points, which is the normal level.
The MSF rate was increased by 200 basis points to 10.25 per cent in July when the rupee dropped below 61 to a US dollar. At the time the repo rate was at 7.25 per cent, but the RBI had capped the borrowing limit from the repo window at 0.50 per cent of banks' net liabilities, or Rs 35,000 crore, daily for all banks put together.
The MSF rate hike by then RBI Governor Duvvuri Subbarao was aimed at tightening liquidity and stabilise the rupee. This is because banks were reportedly borrowing short-term money to play in the rupee forward market to make quick gains as they felt the local currency could drop to 65 against the greenback. In August, the rupee touched a record low of 68.86 to a dollar.
The MSF rate hike increased banks' borrowing cost. This prompted banks to raise their lending rates. Within weeks of the MSF rate hike, State Bank of India, ICICI Bank and HDFC Bank raised their minimum lending rate by up to 25 basis points.
"The average cost of funds has not changed much for the banking sector. While the MSF has gone down, the repo rate has gone up," says Shikha Sharma, Managing Director and CEO at Axis Bank.
In his first policy announcement in September, Rajan slashed the MSF rate by 75 basis points to 9.50 points as the rupee stabilised a bit and raised the repo rate by 25 basis points to tame inflation. In early October, Rajan cut the MSF rate by another 50 basis points to 9 per cent.
The rupee, which is now trading around 61.5 to a dollar, has also found support from receding worries of a US attack on Syria and the US Federal Reserve's decision to defer tapering its quantitative easing programme.
The biggest encouragement to normalise the effective policy rate is good numbers on the external front.
The current account deficit (CAD) shrank to 3.6 per cent of gross domestic product in the January-March quarter from 6.5 per cent in the previous three months, helped by a hike in import duties on gold that curbed demand of the yellow metal. The government has committed to bring down the deficit to 3.7 per cent, or $70 billion, in 2013/14.