Liquidity key to restoring relevance of repo rate

It is widely expected that the central bank will restore the 100 bps corridor between the repo and the MSF rate on Tuesday

In its last monetary policy review on September 20, Reserve Bank of India (RBI) Governor Raghuram Rajan promised he would take steps to bring the money market back to normalcy — a situation in which the repo rate becomes the operational rate.

And, he showed intent — the central bank reduced the marginal standing facility (MSF) rate further in October (after cutting it in the September review) and opened another liquidity window. Now, it is widely expected RBI would restore the 100-basis-point corridor between the repo and the MSF rates in Tuesday’s second quarter review of monetary policy.

Though the corridor could be restored in various ways, the Street feels raising the repo rate 25 basis points to 7.75 per cent and, simultaneously, cutting the MSF rate by 25 basis points to 8.75 per cent is the most probable step. Another option is to cut the MSF rate 50 basis points, though this is ruled out on the grounds that headline inflation is picking up, and this might prompt a rise in the key policy rate.

On July 15 this year, RBI had unleashed a slew of measures, including a 200-basis-point rise in the MSF rate to 10.25 per cent and capping bank borrowings from the liquidity adjustment facility (LAF) window. These steps were aimed at making short-term money dearer so that it wasn’t used for speculative purposes, which were exerting pressure on the exchange rate.

Market participants say making liquidity available to banks is the key to aligning short-term rates to the repo rate; merely restoring the repo-MSF corridor isn’t enough.

At the same time, the Street is aware Rajan wouldn’t allow any sharp fall in the interest rate to dilute the central bank’s hawkish stance on inflation. “The restriction on LAF borrowings, which is 0.5 per cent of NDTL (net demand and time liabilities), should continue. RBI should increase the 0.25 per cent of NDTL borrowing under seven-14 term repo to 0.5 per cent of NDTL. When that is done, the total liquidity the banking system can get between LAF and seven-14-day repo is about Rs 80,000 crore. If the liquidity deficit in the system is Rs 80,000 crore or lower, the MSF ceases to be an operative rate. This would help find a rate between the repo and the MSF rates. The near-term, short-term rates would find a level somewhere in between the repo and MSF corridor. This will also suit the current compulsions of monetary policy. This way, the rate would not go to 7.5 per cent, which is too low, considering the inflation. Also, the rate would not go to nine per cent because that would be too high, given the growth constraints,” said Mohan Shenoi, president (group treasury and global markets), Kotak Mahindra Bank.

Currently, banks can borrow 0.5 per cent of NDTL from the LAF window, against no such restriction in the pre-July 15 days. The market is debating whether the cap would be raised to 0.75 per cent or one per cent; few are expecting a complete removal of the ceiling. “If RBI goes for a cap of one per cent of NDTL for repo borrowings, a large part of the funding would be done through repo, and any requirement above that would go to the MSF window. If not one per cent, they can probably go for a cap of 0.75 per cent of NDTL for banks. I feel RBI might go for a cap of one per cent of NDTL because that is a reasonable signal that the exchange rate market is in control now. This would also be a signal to the financial market to return to normalcy. The decision to increase the repo rate by RBI would be based on its judgement of inflation-growth dynamics. If the cap on repo borrowing is increased from 0.5 per cent of NDTL to either 0.75 per cent or one per cent, it would also help narrow the gap between repo rate and short-term rates,” said Hitendra Dave, managing director and head of global markets (India), HSBC.

In May, the MSF rate was cut 25 basis points. However, in mid-July, RBI had raised the rate from 8.25 per cent to 10.25 per cent to arrest volatility in the rupee-dollar exchange rate. In the mid-quarter review of monetary policy last month, RBI had cut the rate 75 basis points; earlier this month, the rate was again cut 50 basis points. The repo rate was cut 25 basis points in May and 25 basis points in the mid-quarter review of monetary policy in September.