Reserve Bank of India (RBI) had announced its first quarter review of Monetary

Policy 2010-11 on July 27, 2010. Of late, especially after Mr D. Subbarao took
over as Governor in September 2008, RBI has taken some kind of fresh
approach towards issues relating to Monetary Policy and Indian Economy – right
from taking a lot of bold measures between September 2008 and January 2009
to save the Indian Economy from the aftershocks of sub-prime crisis in the US to
the latest first quarter review. Let us examine what are the important aspects of
this new and fresh perspective in the latest monetary policy review.

What’s new?
There are four new areas which RBI has focused on in the latest policy review. They are:
1. Change in policy Stance; 2. Reduction in LAF corridor; 3. Introduction of mid-quarter
review in addition to quarterly reviews; and 4. Expected Outcomes.
1. Change in Policy Stance:
RBI is deeply concerned about rising prices and double-digit inflation in India and
renewed uncertainty in global economic recovery owing to Greek Sovereign debt crisis
and high employment in the US. India’s inflation measured by Wholesale Price Index
(WPI) has been more than 10 per cent since February 2010. However, RBI is optimistic
about the India’s GDP growth in 2010-11 reinforced by the good progress of the South-
West Monsoon, expansion in India’s exports and imports, and double digit growth in the
industrial production. Taking these into consideration, RBI has increased its projection
for India’s GDP growth in 2010-11 to 8.5 per cent from 8 per cent projected in its April
2010 Annual Policy review.

Against this backdrop, the RBI has changed its policy stance decisively to containing
inflation and anchoring inflationary expectations.

2. Introduction of mid-quarter reviews:

Till Now, RBI was undertaking Monetary Policy reviews at quarterly intervals in April,
July, October and January every year. From now onwards, it will carry out mid-quarter
reviews in June, September, December and March; in addition to quarterly reviews. Mid-
quarter reviews will be conducted roughly one and a half-month after each quarterly
review. The rationale behind the introduction of mid-quarter reviews is to inform RBI’s
assessment of economic conditions more frequently to the market participants in line
with major central banks, like, the US Fed and the ECB.
 Rama Krishna Vadlamudi, HYDERABAD August 28, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com
3. LAF corridor shortened:

LAF Corridor

350
Jul.2008
300
Mar.2002
250
Basis Points

200
Mar.2004 Nov.2008
150 Oct.2006 Jul.2010
Apr.2005
100
50
0
Mar.2002 Mar.2004 Apr.2005 Oct.2006 Jul.2008 Nov.2008 Jul.2010

LAF Corridor is the excess of LAF-Repo Rate over the LAF-Reverse Repo Rate. Before
the first quarter review, the LAF corridor was at 150 basis points. On July 27, 2010, RBI
raised repo rate by 25 basis points to 5.75 per cent and reverse repo rate by 50 basis
points to 4.50 per cent; thus effectively reducing the LAF corridor from 150 basis points
to 125 basis points (repo rate minus reverse repo rate = 575 - 450). Repo Rate is the
rate at which RBI charges commercial banks for their overnight borrowings from RBI by
exchanging Government Securities. Reverse Repo Rate is the rate at which RBI pays
commercial banks for keeping their overnight surplus money with RBI while exchanging
Government Securities, under RBI’s Liquidity Adjustment Facility (LAF). LAF is a
mechanism by which RBI adjusts daily liquidity in the domestic money markets by
injecting funds (at repo rate) or by withdrawing them out (at reverse repo rate). This
operation is conducted with the help of exchanging Government Securities.
As can be seen from the above graph, the corridor was at an elevated level of 250 basis
points (bp), which was brought down gradually to 100 bp in April 2005. From there, it
was gradually widened to as high as 300 bp. Later, during the peak of US sub-prime
crisis, this was narrowed down sharply to 150 bp in just three months. Finally, in the first
quarter review of July 2010, this was further shortened to 125 bp.
What is the significance of this LAF corridor? LAF corridor is important from the
viewpoint of short-term interest rates. Short-term interest rates, usually represented by
call money rates and CBLO* rates, are supposed to move in a range between repo rate
and reverse repo rate. Central Banks in general are not comfortable with volatility in
markets. As such, RBI would use this corridor to contain volatility in short-term interest
rates. By narrowing down the difference between repo rate and reverse repo rate, RBI
has expressed its strong desire to contain any wild movements in the call money rates.

(* CBLO-Collateralized Borrowing and Lending Obligation of the Clearing Corporation of India Limited. It is a
money market instrument through which CCIL imparts liquidity to market participants.)

Page 2 of 3
 Rama Krishna Vadlamudi, HYDERABAD August 28, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com
4. Exepcted Outcomes ^:

RBI has expressed that its policy actions are expected to:

Moderate inflation by curbing demand pressures

Maintain conditions conducive to growth

Generate liquidity conditions

Result in reduction of sharp movements in short-term rates

(^ In fact, this section was introduced some quarters back)

Monetary Measures:
The following are the monetary measures undertaken by RBI on July 27, 2010:

1) LAF-Repo Rate is increased by 25 bp to 5.75 per cent wef July 27, 2010

2) LAF-Reverse Repo Rate is hiked by 50 bp to 4.50 per cent wef July 27, 2010

3) The Cash Reserve Ratio (CRR) is kept unchanged at 6.00 per cent

4) Bank Rate has been retained at 6.00 per cent

5) Saving Bank rate has been kept unchanged at 3.50 per cent

Other Measures:
RBI expects that the liquidity position will remain tight even though it may ease a bit
going forward. LAF-Repo Rate has become RBI’s main instrument of monetary policy.
RBI feels there is a need to take a relook at its LAF policy as it has got implications for
monetary policy transmission. At present, the guiding principles of LAF corridor (width of
the policy interest rate corridor as explained in page 2) are: (i). it should be broad
enough not to unduly incentivize banks to place their surplus funds with RBI; and (ii). it
should not be so broad that it leads to greater volatility in short-term interest rates.
Keeping this in mind, RBI has proposed to set up a Working Group to review the current
operating procedure of monetary policy of the RBI, including the LAF.

Disclaimer: Views of the author are personal.

---------------------------------------------------------------------------------------------------------------------
For author’s articles on financial markets, just click any one of the below links:

http://www.scribd.com/vrk100 http://www.ramakrishnavadlamudi.blogspot.com/

http://groups.google.co.in/group/random-thoughts-on-investments/files?hl=en&&sort=date

Page 3 of 3