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RBI doesn't like to be pre-empted

T.B. Kapali

CENTRAL banks do not like to be pre-empted by the markets on issues such as interest rates and exchange rates. And where the market seems to be taking positions on the assumption that the central bank would have to necessarily adopt a particul ar policy stance - for instance, if positions in interest rate sensitive assets are built up on the assumption that the Reserve Bank of India will have to keep interest rates soft, that could indeed provoke the RBI into taking such steps as wou ld disabuse any such market impression.

That could well explain the RBI's decision over the past two weeks to peg the rate at which it provides liquidity support to the markets at successively higher levels - the rate touching 14 per cent on Tuesday from 9.05 per cent on June 5, when the RBI b egan providing liquidity support through a system of reverse repos.

The high liquidity support rate in turn has led other market interest rates - specifically the overnight inter-bank rate much higher, neutralising or even wiping out the positive spread which was previously available between the overnight borrowing rate and the rate on medium/long dated Government bonds.

While concerns about the rupee (which of late has been under pressure) and the build up of maturity mismatches in banking balance sheets too could have been behind the RBI move on higher reverse repo rates, the desire not to be pre-empted also could have played a role in the RBI's decisions.

Indeed, concerns about the rupee can be readily understood and accepted. But whether the RBI indeed was worried by the build up of maturity mismatches (and interest rate risks) in bank balance sheets is open to question. For has not the central bank over the past 1 or 2 years lengthened primary issue maturities (of GoI debt) with some kind of a missionary zeal?

Now, given that the RBI has religiously lengthened the maturity structure of the Government debt and still appears quite intent on doing so, how can it be wrong if the market, on an understanding of the central bank's public debt responsibilities, takes directional bet on interest rates?