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Crossing With Care

One could expect some aggressive measures from the RBI on 27 July
By This weekend, a lot of fingernails will be bitten to the fingertip, metaphorically speaking. On Tuesday, the financial services industry will watch anxiously as the Reserve Bank of India (RBI) presents its first quarterly review of this years monetary policy. In late June, the RBI increased policy rates by a quarter of a percentage point (or 25 basis points) between two meetings, something it has done for a while. The question on everybodys mind is: how big is the hike in policy rates going to be this time? There is little doubt that there will be one: the story of the inflation genie is well known, and it is widely recognised that the central bank will have to act. But policy rates are not the only measures at the central banks disposal: there are reserve requirement adjustments (changes in the statutory liquidity ratio, or SLR, and the cash reserve ratio, or CRR), and perhaps changes in mode of access to liquidity for the banking system. Liquidity is the second genie in the bottle, so to speak. Central bank officials maintain that the overall liquidity within the system is comfortable. Overnight money rates have stayed between the repo (the rate at which banks borrow from the RBI) and the reverse repo (at which banks lend to the RBI) rates: an interest rate corridor of sorts. Banks still have in excess of Rs 50,000 crore a day that they place with the central banks liquidity adjustment facility. Yet, banks and bond markets talk of tight liquidity, which suggests first that most of the liquidity is held by a handful of banks, and second that credit growth has been accelerating and increasing loan demand at banks. This much emerges from a review of the RBIs weekly statistical supplement, a publication that provides fortnightly data (because banks report to RBI on a fortnightly basis): deposit growth over the last six weeks or so has been slower than credit growth over the same period. So interest rate hikes may come to the deposit market too, as banks hunt for liquidity. Till recently, the largest supplier of liquidity was capital inflows: post the European crisis, they have abated somewhat, and under current conditions, there will be no great gush. Let us also not forget that the exchange rate has been weakening, to a little over

Rs 47 to the US dollar, which is usually a deterrent to inflows (the RBI had expected such a gush in April, when its annual policy was unveiled). So what can the central bank be expected to do? Many believe that it boils down to managing a delicate balance between inflation and liquidity pressures. Dealing with the first genie may call for some aggressive action, even a 50 basis points hike on the repo and reverse repo rates. On the other hand, managing the liquidity situation may call for restoring the half per cent temporary reduction in SLR to 24.5 per cent and as a second step raising the reverse repo rate by 75 basis points, and narrowing the corridor, giving the surplus SLR banks a better return. We lean towards thinking that there will be a 25 basis point hike in the repo and a 50 basis point hike in the reverse repo rate, and perhaps a restoration of the temporary SLR cut. But as Mark Thoma, economic professor at the University of Oregon said about watching the US Fed, the secret is to see the data as the RBI sees it, not the way we see it. Come Tuesday, well know.