RBI need not hike rates now
The RBI can use the LAF (Liquidity Adjustment Facility) for policy transmission rather than tweaking policy rates.
The RBI has been raising the repo and reverse repo rate for the last eighteen months to bring down inflation expectations, which are trending at close to 9.5% levels. The repo rate at present is at 8% while the reverse repo rate is at 7%. Banks can borrow as much as they want at the repo rate of 8% and lend as much as they want at the reverse repo rate of 7%. At present banks are borrowing around Rs 40,000 crores on a daily basis from the RBI at the repo rate of 8%. The fact that the RBI is accepting all bids placed for repo at 8% is keeping overnight money market rates at close to repo rates of 8%. Call money, which is uncollateralised overnight borrowing, trades at repo rate of 8% while repo and CBLO (collateralised borrowing and lending) where funds are lent against government securities trades below 8%.
The RBI will have to a fine balancing act between bringing down inflation expectations and keeping the economy on the growth path. The recent event in the US and Eurozone has hurt growth sentiments while domestic inflation continues to remain at higher levels. The better than expected IIP (Index of Industrial Production) data for June where IIP growth came in at 8.8% against market expectations of 5.7% does not change domestic growth sentiments. The volatility in capital goods index which showed a growth 37.7% year on year as compared to the previous years growth of just 3.7% is clouding the IIP growth numbers. RBI in all likelihood will reduce GDP growth forecast from 8% due to domestic rates, domestic inflation and external events. However, despite reducing growth forecasts, RBI will still have to maintain policy rates at higher levels due to inflation ruling at over 9.5% levels.
The RBI can take up overnight rates to over 8% levels by rejecting bids for repo in the LAF auction if it believes that bringing down inflation expectations is the need of the hour. Alternatively, the RBI can ease the liquidity situation by injecting funds into the system and make the system bid for reverse repo on a daily basis. The RBI can then reject bids for reverse repo to bring down overnight rates to below 7% levels if RBI believes that focus on growth is the need of the hour. In using the LAF, the RBI need not make headlines through its policy rates and at the same time achieve its objectives.
The RBI can make overnight rates unpredictable by rejecting bids in the LAF auctions. For example if banks have bid for repo at 8% to borrow funds from the RBI, and the RBI rejects part or all the bids, overnight borrowing rates will shoot up. This shooting up of overnight borrowing rates will make banks more careful in pricing assets and utilizing funds that become scarce once RBI stops intervening. Banks will also price deposits better to attract sticky liquidity.
Similarly RBI by rejecting reverse repo bids in the LAF auction sharply bring down interest rates, as banks will then lend money in the market at market determined rates. Cost of funds in the system will come down if the system in fund surplus. Lower cost of funds will then act as a catalyst for economic recovery.