Why RBI has hiked the Base Rate on Jul 15 & Implications

Reserve Bank Of India (RBI) announced several measures day before yesterday late evening to tighten liquidity in the system and arrest depreciation of rupee.  Why RBI wants to tighten liquidity and why the urgency.
RBI had tightened liquidity to support rupee during Asian crisis:
Historically, During the Asian crises of 1997-98, the RBI raised its benchmark interest rate by three percentage points in one go to 8%, in order to attract capital from foreign investors. The RBI had raised the bank rate and cash reserve ratio of banks too. This had sucked out liquidity, and interest rates had skyrocketed. This checked the run on the rupee.

The reason for this move and its impact:
Liquidity had eased considerably in June and that had brought the overnight rates (also CP, CD) rates below the Repo rate. With these measures, RBI will be able to raise the effective short term interest rate considerably without hiking the policy rate.
Banks usually borrow from RBI through the LAF window at the Repo rate of 7.25% against its investment in approved securities (Gsecs, SDLs) that are in excess of Statutory Liquidity Ratio requirements (SLR: 23%). If a bank falls short of approved securities, it can still borrow about 1% of NDTL by pledging the SLR securities but at MSF rate, that used to be 100 bps higher than Repo rate.
Now RBI has capped the overall borrowing through at Repo rate at 1% of Net Time and Deposit Liabilities (NDTL), or Rs 75,000 cr. Also, it increased the MSF rate by 300 bps above Repo rate or 10.25%. Banks borrowed Rs 92,000 cr yesterday through LAF-Repo. So, restricting LAF borrowing to Rs 75,000 cr only will have a significant impact on overnight borrowing rate. It means banks can borrow only Rs 75,000 cr at 7.25% and the rest will have to be borrowed at higher MSF rate of 10.25%.
RBI will additionally squeeze out liquidity by selling Government bonds worth Rs 12,000 cr on 18th July. (Previously RBI has been injecting liquidity by buying government bonds through OMOs). Banks will be pushed to borrow through MSF as liquidity tightens. Banks have the option of using MSF facility to borrow additional funds at 10.25%. This will raise sharply the short term rate and make the liquidity squeeze meaningful. The short end of the curve will move up. The longer end will be also impacted but may be less than the shorter end. So, yield curve is expected to flatten.
The primary objective of the RBI is to support the rupee by increasing short term rate and interest rate differential and stem capital outflow. It will discourage speculators to short the currency. As liquidity tightens and short term rate spikes, cost of borrowing in rupee term increases and that will encourage speculators to sell dollar. It is a traditional text-book response to defend currency.
It should be understood that these measures are temporary in nature and reversed back again as currency stabilizes. RBI did not touch the Repo rate because it is not possible to keep changing Repo rate frequently as it will send out a confusing signal to the market.

The market had an immediate knee jerk reaction to RBI’s announcement yesterday. Call rate moved to 8.40% to 9.25%. 10-yr benchmark yield crossed 8%. Rupee opened at 59.20 vs US dollar compared to previous close of 59.90.
In a typical text book approach to stabilize currency, central banks usually hike policy rate to increase interest rate differential to attract foreign capital. Higher interest rate also lowers domestic growth, inflation, helps narrow CAD and stabilizes currency. Recently other emerging nations like Brazil and Indonesia have increased policy rates by a larger-than-expected 50 bps.
However, RBI did not touch the Repo rate as it did not want to indicate a start of tightening cycle as it believes that the current currency weakness might be temporary.
The actual impact of these measures will be seen in coming days. If these measures are accompanied by further reform initiatives by Government in coming days, it might be overall positive for the currency.

However, these measures do not address the fundamental issue of wider CAD and risk of financing the CAD. We would have preferred a scenario of easy liquidity to support growth along with tight fiscal policy. But if these measures are reversed after a short period as confidence in rupee returns, the impact in the economy will be muted.
On the other hand, there might be other unintended implications. High interest rates for longer period, at this stage when growth is struggling to revive, will have an adverse impact. The earlier growth estimate of 5.7% for FY14 will have to be lowered. This will also lower the quantum of rate cut expected earlier. However, lower growth will weaken domestic demand further and help narrow trade deficit and CAD. Inflation will also soften. As growth struggles, RBI can aggressively cut rate again to support growth once external risk goes down and rupee stabilizes.
It remains to be seen if these measures will attract inflows into debt market as recent outflows were not India specific and there were outflows from all emerging economy debt markets. The impact of these measures on growth sensitive equity inflows needs to be seen too.

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