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RBI has cut the MSF rate. It must also review other decisions in its misguided defence of the rupee.

RBI has cut the MSF rate. It must also review other decisions in its misguided defence of the rupee.

The liquidity conditions in the Indian economy have remained tight since the bank rate hike of mid-July. The borrowing from the repo window was also restricted in the mid-July move and the Marginal Standing Facility (MSF),normally considered a penal rate,became the operational monetary policy rate. It was eased by 75 basis points with the credit policy announcement in late September and has now been cut further,by 50 basis points. This is a step in the right direction as it would move it towards 8.5 per cent,which would bring it to 100 basis points above the repo rate,which currently stands at 7.5 per cent. In principle,cutting rates could impact the rupee adversely,but considering the low level of openness of the Indian debt market,a change in interest rates has little direct impact on the currency. When rates had been raised,the currency had actually depreciated.

The RBI’s Monday cut,which took the MSF rate from 9.5 per cent to 9 per cent,will help ease interest rates in India,which had shot up by as much as 400 basis points and inverted the yield curve when the RBI raised the MSF rate by 200 basis points to 10.25 per cent in mid-July. This is good news and it will ease liquidity conditions in the market. An RBI committee headed by Deputy Governor Urjit Patel is working on a new monetary policy operational framework. Until the committee makes its recommendations and a new framework is put in place,one may expect that the RBI will move back,albeit slowly,to the framework that existed before mid-July — where the repo was the policy rate and the MSF was 100 basis points above it and the reverse repo 100 basis points below it. However,since the borrowing window for the repo is still restricted to 0.5 per cent of the net liabilities of banks,Governor Rajan’s announcement to make the repo rate the policy rate will become operational only when the restriction on the borrowing limit is eased.

The Indian economy is facing a worsening slowdown and the interest rate defence of the rupee has proved to be very costly. The sudden and huge increase was clearly not to control inflation and was more than what even a CPI inflation target would have warranted. It is good that the RBI is reviewing its ill-thought-through measures. It needs to reverse all such steps as soon as possible to prevent long-term damage.