The October rate increase by the RBI was a good move. However, the central bank is tightenening money supply whilst the banks have tonnes of cash that it has injected. The Reserve Bank of India on 7 October increased the repo rate for the first time since February 2023 by 0.50% to 5.50%, and announced a “calibrated tightening” policy.

Indian banks had excess cash on their books having averaged at ₹5.9 lakh crore daily since August on the same day. Both facts are self-inflicted by the RBI. The central bank is to tighten the money supply, but it’s also picking up money, that it has been printing for four months. The walk needs to be backed. However, if that liquidity isn’t taken off the market, the new rate will be a signal, not a limitation.

A rupee defence that has been successful

The problem started abroad India. In September, the conflict in West Asia once again flared up and the Indian crude basket rose from $82 a barrel in July to $116. FPIs have withdrawn $10.3 billion since April and the rupee fell below 95 to dollar. The RBI in June opted not to intervene in the currency market by changing interest rates. It opened a special swap window for FCNR(B) deposits which are foreign-currency deposits of the non-resident Indians with the Indian banks. Banks could find a way to hike their 3–5 year dollar deposits, exchange dollars with the RBI for rupees and then get their dollars back from the RBI at maturity. The RBI took the cost of hedging, which was estimated to be 3-3.5% per year, and waived the requirement for the deposits. It was based on Raghuram Rajan’s playbook in 2013 and it turned out to be far beyond expectations. By 31 August, banks had mobilised nearly $127 billion, which is nearly five times the amount raised in 2013 ($26 billion). The window was closed a month prematurely. Foreign exchange reserves dipped briefly to a record high of $740.8 billion.

The currency of the day was $1 = 95 Rs Here is the catch.

The RBI has put in approximately ₹95 for each dollar swapped with it. The gross addition of liquidity is close to ₹12 lakh crores in new rupees. This surplus was a record ₹11.6 lakh crore on 7 September. It was a natural consequence of the effects. The average gap between the overnight call rate, which the RBI is supposed to keep at the repo rate, and it has been around 14 basis points. The Governor himself admitted that the deposit rates eased. Bank credit has expanded by 18.1%, compared to 10.4% a year ago. At the time inflation turned monetary conditions eased through the back door. Consumer price inflation was at 4.8% in August. Core inflation rose from 3.9% three months ago to 4.2%.

Today, the inflation in items above 4% accounts for approximately 37% of the consumer price basket, compared to 23% in the previous month (April).

The right decision, but not the right job.

None of this makes it a bad choice. The Monetary Policy Committee (MPC) projects that inflation will hover near 5.8% for the next three quarters and get close to its upper limit of 6% in the December quarter. But critics have argued that a rate hike would be unable to pump oil or bring rain. That is correct, but a supply shock need not permeate wages, prices, and expectations. The economy can afford the insurance with growth at 7.8% in the June quarter. The change of stance is more important than the 25 basis points. The Governor has given the bond market some guidance as to where the risks lie by stating that the next step “can only be a rate hike or a pause”. But if market rates follow a policy rate, a policy rate bites! Once the call rate holds steady 14 basis points below the repo rate, over half of this increase is lost from the economy. With inflation forecast around 5.8%, a 5.50% repo rate ensures that the real rate of interest is negative or at least zero. Policy is now less lenient. It is not tight.

Borrowed tools for a lasting problem

The RBI is well aware of this and has been adding liquidity in a big way. It has been holding 55 variable rate reverse repo auctions since the August meeting and has sold a total of ₹1.0 lakh crore of bonds in the open market. However, reverse repo auctions are designed for short-term excesses. They are not compulsory and the funds are returned at the time of the auction’s maturity. They were reluctant in September when banks bid for just ₹2.59 lakh crore for a 30-day auction of ₹7 lakh crore. What’s the point of tying up money to pay back for a month just because the demand for loans is rising at 18%? The FCNR(B) liquidity is not short-term. It will remain in the system for three to five years, and it requires more durable instruments to maintain that: either larger outright bond sales, or an increase in the cash reserve ratio (currently 3%). The economists estimate that the 50 to 100 basis points would take away ₹1.4 to 2.8 lakh crore. Both are unpopular. Bond sales drive up the government borrowing costs when the 10-year yield is already at near 7.27% and a higher reserve ratio is a tax on banks. Well, that’s the cost of permanent sterilisation. It can only be deferred later, which means the repo rate is to be leaned upon later.

The bill is due in 2029.

There’s also a longer shadow. Those dollars have to be returned to the RBI when the swaps expire from 2029 to 2031. Not all of the capital is patient NRI savings: banks reportedly have loaned depositors nine to nineteen times their money to invest in the scheme. Money flows out if the maths changes. In 2016, India redeemed the 2013 deposits successfully, but it was just a fifth of this bill. The impossible trinity comes undauntingly as the textbooks say it does. A country cannot keep its capital freely flowing, simultaneously maintain an independent monetary policy and manage its exchange rate.Unless a country is willing to pay to sterilise its capital flows, it cannot do all three simultaneously. The RBI acquired stability in the currency in June. The invoice is now offered in money market. A price rise in October was needed. Now the challenge for “calibrated tightening” is to see if the call rate will hit 5.50% on the committee’s next meeting on 2 December. If not then RBI will have hiked its rate without hiked the cost of money.