The Reserve Bank of India took further steps on Tuesday to tighten banking system liquidity and support the falling rupee, aggressively shrinking its daily borrowing window and ordering banks to set aside high cash reserves on a daily basis. Just after a week of taking exceptional measures to stem the currency's decline, the RBI made liquidity tighter and costlier for banks, which in turn is expected to increase demand for rupees and reduce volatility.
The RBI lowered the overall limit for borrowing under the daily liquidity adjustment facility (LAF) - which offers funds in exchange for collateral - for each bank to 0.5 percent of deposits from 1 percent. The central bank also said banks needed to maintain 99 percent of their daily cash reserve ratio requirements - the deposits they must set aside - with the RBI, as against 70 percent now.
"These measures of trying to reduce domestic liquidity and making funding costs higher, may not be very effective to support the rupee," said Siddhartha Sanyal, chief India economist at Barclays. "There is a risk that capital inflows in the equity market can get dented as these steps put more pressure on growth in the medium term," Sanyal said.
The LAF adjustment is based on deposits outstanding as of the last Friday of the reporting cycle two weeks prior to the current one. The reserve requirement change takes effect from the two-weekly period starting July 27. The rupee had steadied somewhat since the RBI took unprecedented steps last week to try to create demand for the currency by aggressively draining cash from money markets and sharply raising short-term interest rates. Some of the rupee's fall - 12 percent since May and including a record low of 61.21 to the dollar on July 8 - reflects a broader selloff in emerging markets on signs the United States is preparing to wind down its economic stimulus.
However, a record high current account deficit, concerns over a decade-low growth and now uncertainty over the central bank's monetary policy stance, which had been on a easing path until May, have prompted foreign investors to remain persistent sellers of Indian debt since late May of $11.5 billion. The RBI also announced sale of 60 billion rupees of short end cash management bills to drain out more cash from the banking system.