Friday, September 20, 2013

RBI-Monetary Policy Review

 Reserve Bank of India's new governor Raghuram Rajan has announced his first monetary policy on Friday. He has lowered the marginal standing facility rate by 75 basis points to 9.5% from 10.25% but raised the policy repo rate under the liquidity adjustment facility by 25 basis points to 7.5% from 7.25%. Both the measures are effective from today.

What is marginal standing facility?

Marginal standing facility is a window for banks to borrow from Reserve Bank of India in emergency situation when inter-bank liquidity dries up completely. Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate under liquidity adjustment facility or LAF in short

What is liquidity adjustment facility?

Reserve Bank of India's liquidity adjustment facility of LAF helps banks to adjust their daily liquidity mismatches. LAF has two components -- repo (repurchase agreement) and reverse repo. When banks need liquidity to meet its daily requirement, they borrow from RBI through repo. The rate at which they borrow fund is called the repo rate. When banks are flush with fund, they park with RBI through the reverse repo mechanism at reverse repo rate.

What is the policy rate?

Repo rate is considered as the policy rate as repo is the widely used instrument between banks and RBI. Earlier bank rate was considered as the benchmark but it has lost its relevance as banks seldom take refinance from RBI at bank rate. Any change in repo rate signals RBI's interest rate stance.

Why RBI reduced marginal standing facility rate while it raised repo rate?

RBI had raised the marginal standing facility rate to 10.25% as a liquidity tightening measure and to prevent speculative use of rupee in buying dollar. Now, a reduction in the MSF rate perhaps indicate that RBI is now comfortable about the rupee-dollar movement. The rupee has bounced back some 8% from its record low of 68.80 in the last fortnight. The rupee-outlook has also improved as the Federal Reserve refrained from reducing the amount of its bond purchases under quantitative easing programme. Global investors were earlier withdrawing their investment in emerging countries to seek better returns in dollar-denominated investment withdrawal of quantitative easing means fall in liquidity and rise in bond prices in the US.

On the other hand, RBI increased the repo rate as it wants to continue its fight against inflation, which is still on the higher side above RBI's comfort level. Rise in repo rate may push borrowing rates up for both companies and individuals. Companies may have to shell more interest rate for borrowing for building new projects or expanding an existing one.

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