RBI has hiked the repo rate — the rate at which RBI lends to banks — to 8 per cent in an attempt to reduce inflation. Year on year, IIP growth has deteriorated from October 2007 onwards, with a latest data point at 7 per cent for April 2008. There has been a substantial change in monetary policy from October 2007 onwards. Until then, RBI was pumping liquidity into the system by purchasing dollars and then sucking it out by selling government bonds: in this configuration, the government was bearing the costs of subsidising exporters with a pegged rupee-dollar rate. Since October 2007, RBI seems to have placed the costs of the exchange rate pegging on banks, households and industry by increasing the cash reserve ratio (CRR) of banks.

In the last two years, while there was an increase in liquidity in the system due to dollar purchases of RBI, this liquidity was sucked out by selling Monetary Stabilisation Scheme (MSS) bonds. Here, the costs of running the pegged exchange rate regime were placed upon the ministry of finance which has to pay interest on the MSS bonds. However, after October 2007, RBI stopped selling MSS bonds.

The limit on MSS issuance, the amount of bonds that the government had permitted RBI to sell, is Rs 2.5 lakh crore, while the outstanding amount in October 2007 (and since then) was only Rs 1.7 lakh crore. In other words, RBI could have continued to sterilise its currency trading through the sale of government bonds. Hence, the shift in policy is surprising. As is typical of the non-transparency of RBI, there was no announcement that the mechanisms of monetary policy had changed.

... contd.