Choice of Instruments

The Reserve Bank of India’s (RBI) third quarter review of monetary policy in 2009-10 was awaited with considerable anxiety since the economy is indeed at a critical moment – the recovery has to be managed even as food inflation remains high and threatens to spill over into manufacturing, ending up in generalised inflation. Foreign capital inflows have also been surging, which could put further pressure on liquidity. Some expected that the RBI might not increase policy rates, but that the excess liquidity might be absorbed through a hike in the cash reserve ratio (CRR). Others expected that there could be a combination of a rate hike of 25 basis points and a CRR hike of 25 to 50 basis points. RBI Governor D Subbarao took the market by surprise when only the CRR was hiked by a sharp 75 basis points to effectively absorb about Rs 36,000 crore from the system.

If we look at the earlier tightening phase (September 2004 to August 2008), when the reverse repo rate was raised from 4.5% to 6%, the repo rate from 6% to 9% and the CRR from 4.5% to 9%, there were only a few occasions when both the CRR and policy rates were changed together, for whatever reason. Therefore, the January 2010 decision is not without precedence. Since 2004, there has been an evolution in and learning about the choice of instruments. After a switch to indirect instruments, policy rates and the Liquidity Adjustment Facility (LAF) window were considered optimal to absorb and inject liquidity in a flexible manner depending upon the market conditions. But the LAF was overburdened with massive capital inflows and necessitated the innovation of the issuance of the Market Stabilisation Scheme (MSS) securities, which complemented the LAF. Huge absorptions under the LAF also added to the opportunity cost of holding foreign currency reserves.