Is Raghuram Rajan's repo hike a negative?

On Friday, after the announcement of the midterm policy review statement, wherein the Reserve Bank of India (RBI) hiked the repo rate by 25 basis points (bps) and lowered the Marginal Standing Facility ( MSF) rate by 75 bps, the markets reacted negatively. In the aftermath of the unexpected gift from the US Fed—the deferring of QE tapering—the markets found it hard to stomach the Indian central bank's bitter pill of a repo rate hike. The Sensex fell 1.85% while the BSE Bankex lost 4.18%. In popular perception, a repo rate hike is deemed as anti-growth. But is it really so?

At present, banks can borrow only a limited sum of Rs 38,000-40,000 crore at the repo rate. Any amount above this level has to be borrowed at the MSF rate. Since the banking system's overnight borrowing requirements are higher than this cap, the MSF has come to be the effective borrowing rate for a large portion of the funds borrowed by banks. This rate had been hiked by 200 basis points (bps) on July 15 and has now been reduced by 75 bps to 9.50%. This will bring borrowing costs down for the banking system. Short-term interest rates, which had spiked after the July 15 liquidity tightening measures, will soften.

With the US Fed postponing its tapering, the immediate risk to the rupee and the markets from a possible outflow of funds has been deferred. This called for some relief from the liquidity tightening measures, hence the cut in the MSF rate. Limited relief will also come from reduction of daily cash reserve ratio (CRR) maintenance requirement from 99% to 95%. At the same time, the tightening measures can't be completely unwound because QE tapering will take place eventually.

Now, to turn to the 25 bps hike in the repo rate to 7.50%. At one level, it is superfluous since the repo rate, as argued, is the borrowing rate for only a portion of total bank borrowings. However, with this hike the central bank has signalled its vigilance against inflation. WPI inflation has been rising for the last three months and CPI inflation refuses to budge below double digits. Furthermore, inflationary pressures are building up with the pass-through of fuel price hikes into the economy, and the rupee's depreciation, which has led to cost of imported products rising. The hike in repo rate also aims at making it, and not the MSF, the effective policy rate once again, as the exceptional measures of July 15 are unwound.

As for promoting growth, for the present the RBI has left this task to the government, which has more levers in its hands and is better equipped to do so. The RBI seems more intent on fighting inflation.

In totality the mid-term policy review should be viewed as a fine balancing act and not as an anti-growth move by the central bank.