On Oct 30, 2012, Reserve Bank of India (RBI) announced its Q2 monetary policy. The whole industry was waiting for RBI to announce some measure to boost the economy. On that RBI slashed Cash Reserve Ratio (CRR) by 25 basis points from 4.50% to 4.25%.(CRR is the share of deposits banks must keep with the central bank). This reduction in CRR would inject 175 billion rupees of primary liquidity into the banking system. Industry was expecting that RBI would also reduce interest rates that can help industry and end consumers with reduced borrowing cost. But contrary to the expectation, RBI kept its key policy rates unchanged. So repo rate at 8.00% and reverse rate stays at 7.00%, the same level it has been at for the past six months. Repo rate is a mechanism of monetary policy at which the RBI lends money to commercial banks.Whenever banks have any shortage of funds they can borrow from RBI at the repo rate. A reduction in the repo rate helps banks get money at a cheaper rate and hence can further pass on the benefit to the users by reducing the prime lending rate. This is the 8th time CRR ratio has been changed since 2009 and 4th time this Calendar year. In 1992 CRR ratio was 15% of total deposits of banks.

The 25 basis point CRR cut will give room for more credit to the productive sector and, to some extent, impact the cost of banks but 0.75 percentages additional provisions on standard restructured assets surprised the banks. The benefits arising from CRR cut to banks will be offset by the additional provisioning requirements on restructured loans.

RBI governor mentioned that interest rates are kept unchanged because the priority for him is also to manage inflation apart from economic growth of the country. In the last 2 years economic growth rate of India has slow down. The RBI lowered its FY2013 growth estimate to 5.8 per cent from 6.5% and raised its inflation estimate to 7.5 per cent from 7 percent.The markets have reacted quite negatively after the RBI’s decision to keep the interest rate unchanged. All the interest rate sensitive sectors have fallen sharply. Bank Nifty was down by 2.2 percent to 11222.8 (its lowest since September 21) while 1.1 per cent drops in the BSE Sensex. The rupee was, however, marginally up and closed a shade higher at 53.97 to the dollar after a weak beginning. The 10-year government bond traded at 8.18 per cent, down 5 basis points.

The RBI said in its guidance, “The reduction in the CRR is intended to pre-empt a prospective tightening of liquidity conditions, thereby keeping liquidity comfortable to support growth. It anticipates the projected inflation trajectory which indicates a rise in inflation before easing in the last quarter. While risks to this trajectory remain, the baseline scenario suggests a reasonable likelihood of further policy easing in the fourth quarter of 2012-13. The above policy guidance will, however, be conditioned by the evolving growth-inflation dynamic.”
RBI Governor said “We expect December inflation to peak at 8.5 per cent and come down to 7.5 per cent in March. This falling trajectory provides the RBI with an opportunity to implement “further policy easing” in 4QFY13, depending on the growth-inflation dynamics. We expect the RBI to ease repo rates by 50 bps in 4QFY13 based on our estimates of growth-inflation and CRR by 25 bps in the remaining of FY2013 (dependant on developments on liquidity) and balancing the current growth and inflation situation needed a calibrated approach which would support growth, easing of supply constraints but at the same time helping ease inflation.”

Now, RBI would prefer to watch the government’s policy reforms. If reforms go ahead as planned then inflation would come down. This in turn may prompt RBI to cut down the rate and it will encourage the economic growth of the country.