How RBI is battling currency volatility

Desperate measures: To stabilise the floundering rupee, the RBI has readjusted the bank rate to 10.25% to align it with the marginal standing facility rate. This could make retail loans costlier. Gaurav Choudhury reports.

The Reserve Bank of India (RBI) on Monday announced corrective measures to arrest the persistent fall in the rupee. HT explains the interplay between banks' borrowing costs and its effect on consumer lending rates and exchange rates.

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What has the RBI done?
Late on Monday, RBI moved in to check speculation in the currency market and fixed a daily limit on how much banks can borrow from the central bank -- 1% of banks' deposit base or R75,000 crore for the entire banking system. If a bank requires more funds, it can borrow emergency money using the marginal standing facility (MSF) at sharply costlier 10.25% interest rate from 8.25% earlier. This, however, may push banks to raise lending rates for auto, home and other borrowers. The central bank will also sell government bonds worth R12,000 crore in the secondary market to suck out liquidity.

What is marginal standing facility (MSF)?
The MSF rate is the rate at which banks borrow from the RBI during periods of acute liquidity shortage using their statutory liquidity ratio (SLR) securities as collateral.

When do banks resort to borrowing through the MSF?
When banks are extremely short of funds, they are willing to pay a higher interest rate to borrow extra money from the RBI even at a much higher rate.

How will a hike in the MSF rate help currency volatility?
The rupee has slid more than 13% since May. While this is partly explained by the foreign investors pulling out from Indian equity and debt markets fearing a winding down of the US monetary stimulus programme, there is also a speculative component that is hammering down the rupee. By making it costlier for banks to borrow, the RBI wants to discourage banks' lendable resources from being used for taking speculative positions on the rupee.

What is statutory liquidity ratio (SLR)?
Apart from keeping a portion of deposits with the RBI as cash, banks are also required to maintain a minimum percentage of their deposits with them at the end of every business day, in the form of gold, cash, government bonds or other approved securities. This minimum percentage, which now stands at 23%, is called SLR. While cash reserve ratio (CRR) is maintained in cash form with RBI, SLR is maintained in liquid form with banks themselves.

What is repo rate?
It is the rate at which the RBI lends to banks. A lower repo reduces banks' borrowing costs goading them to cut interest rates for final home, auto and corporate borrowers.

What is reverse repo rate?
The reverse repo is the rate at which RBI borrows from banks to suck out liquidity.

What are policy rates?
The policy rate acts as the guide for final lending rates that banks charge from borrowers. In tight liquidity situations the repo rate acts as the policy rate. In cases of excess liquidity, when banks park money with the RBI from their pool of lendable resources, the reverse repo rate is the policy rate. A higher reverse repo would give banks incentive to park money with the RBI, reducing liquidity and demand. A higher reverse repo rate sucks cash from the system to stymie demand and cool prices.

What prompted the RBI to maintain a status quo on policy rates?
Skyrocketing onion and vegetable prices and costlier staples such as rice and wheat pushed India's wholesale price index (WPI)-based inflation to 4.86% in June, adding to a range of problems for the government battling to the steer the country out of a web of economic mess in an election year. The latest spike in WPI inflation, which was at a 40-month low of 4.7% in May, has largely been driven by high food prices that grew at 9.74% in June compared with 8.25% in May. A sub-5% WPI inflation is still well within the RBI's comfort zone, but with high retail inflation that threatens to reach well into double digits this month, experts reckon that the central bank is unlikely to cut lending costs in its July 30 review meet.

Moreover, the sharp slide in the rupee, which has fallen nearly 13% since May, will fuel inflation further by making most imported goods such as crude oil costlier. Consumer price index (CPI)-based inflation — a more realistic index because it measures shop-end prices — grew 9.87% in June from 9.31% in the previous month, on costlier vegetables and food items.

As long as CPI inflation remains close to double digits and the balance of payment is at risk, analysts expect the RBI would have little room to cut interest rates now.