Rajan's mixed response suggests crisis not over

Partial rollback of July's tightening to normalise near-term rates but repo rate rise suggests risks persist

On the face of it, the Reserve Bank of India’s (RBI) new boss, Raghuram Rajan, has sent out mixed signals, by cutting short-term rates and raising the repo rate. The move hasn’t pleased all but he never promised to do that. While he has attempted to normalise policy rates by delivering what the market was crying for — a cut in the Marginal Standing Facility (MSF) rate of 75 basis points to 9.5 per cent — the repo rate increase to 7.5 per cent suggests he is keeping his options open. The gap between repo and MSF rate now stands at 200 basis points. In a single stroke, Rajan has brought down the cost of funds for private banks that depend on wholesale funding but this shouldn’t be interpreted as a sign of possible monetary easing.

As and when the currency settles, which might not be a long way off, Rajan has made clear his intention to bring down the difference between the MSF rate and repo rate to 100 basis points. The fact that the daily minimum CRR balance requirement has been brought down to 95 per cent of the requirement instead of 99 per cent is also a sign that he intends to cut the stress in the banking system.

However, by increasing the repo rate, he has left the window of tightening open, if required. While the current re-adjustment of rates will bring down cost of funds for banks by 40 basis points, the July measures have not been entirely rolled back, as currency risks are not entirely over. A rollback of QE3 is a given and the collateral damage, too, is inevitable. Thus, the mix of relaxation and rate rise suggests the latter window is not closed, if inflation and currency risks don’t abate. Dhananjay Sinha of Emkay Global thinks RBI is decisively moving away from its earlier short-term focus on managing exchange rate stability, to a far more formidable task of addressing structural issues and inexorable inflationary conditions.

Rajan’s mixed response also indicates he is fully aware of the risks the economy continues to face, which the Fed Reserve’s “no taper” decision will not solve. The only thing apparent from the partial rollback of July’s measures is that the immediate risks to the currency have somewhat abated. Of course, that’s a positive but Rajan’s own measures are beginning to rake in the dollars. Till Thursday, $466 million have come in through the FCNR(B) route and another $917 million have come through the swap facility.

According to Siddhartha Sanyal, chief economist of Barclays, depending on the trajectory of the rupee and level of flows under the foreign currency non-repatriable (FCNR) deposit scheme, this ‘normalisation’ will take place during the fourth quarter. However, inflation will continue to be Rajan’s Everest, as the latest headline print of 6.1 per cent is higher than the central bank’s 5.5 per cent expectations. The repo rate rise is symbolic of Rajan’s commitment to fighting inflation. So, rates are unlikely to ease anytime soon.