An unambiguous signal

RBI returns to normalcy, and a single instrument

Perhaps the biggest lesson of the past decade is that, regardless of fundamentals, more liquidity is always good for financial markets. This was amply demonstrated on Tuesday when, contrary to past patterns, equity indices surged despite the Reserve Bank of India (RBI) increasing the benchmark repo rate by 25 basis points. The reason: liquidity was enhanced by bringing down the marginal standing facility (MSF) rate by 25 basis points. Consequently, the liquidity adjustment facility (LAF) corridor is now 200 basis points wide, with the repo rate in the middle, just as it was before the exceptional policy measures were taken in mid-July. This is a significant acknowledgement of a return to stability in the currency market, though full normalcy is yet to be restored. Banks are still subject to individual limits on access to borrowing from the repo window and oil companies still have special access to foreign exchange. However, it is only a matter of time until these measures are also reversed. One important initiative in this regard is the expansion of the term repo window. Inducing banks to borrow for 7-14 days instead of overnight will help them develop more efficient liquidity management practices as well as develop a more robust short-term money market.

However, beyond the liquidity measures, the unambiguous message from the policy statement is that inflation has re-emerged as a threat and that this will be the RBI's priority. The signal is that, the LAF corridor having been normalised, the repo rate is once again going to be the active policy instrument and, given the inflation projections articulated in the policy statement, this can only move in one direction - up. How far up is anybody's guess; but the absence of a reference to core inflation in the statement and a projection for inflation measured by the consumer price index (CPI) of above nine per cent by year-end suggest that the latter will now drive policy decisions. By that yardstick, then, it could be argued that there is still a significant need for rate increases.

This being a half-yearly statement, regulatory and development measures were also announced. While many of the initiatives announced by Raghuram Rajan in his inaugural statement as governor of the RBI are being dealt with by various groups, there were at least three significant measures. First, there is now an explicit incentive for foreign banks to operate as wholly-owned subsidiaries instead of branches. Of course, this may be neutralised by the larger priority sector mandate imposed on them last year; the two may need to be harmonised. Second, in order to stimulate corporate debt markets, banks are now allowed to provide partial credit enhancement to bonds. Explicit guarantees are not yet allowed, but as long as some rating upgrade is feasible, there will be a positive impact on the market. Needless to say, many other things also need to be done, particularly to activate the government securities market. Third, an inflation-indexed bond based on the CPI will be issued. This needs to be marketed creatively to find acceptance; but once it does, it is an important potential substitute for gold. Beyond these, a number of other measures relating to cash management, facilitation of mobile payments and so on demonstrate Dr Rajan's commitment to a "hundred small steps" approach.