Its Chinese counterpart made the move a couple of days ago. The RBI could not afford to be left behind. It too made up its mind on hitting the gear for sucking up liquidity. The Indian central bank released its third quarter review of Monetary Policy today. Not willing to let loose the inflationary spiral, it has come down strictly on the excess liquidity floating around the system.

The instrument used has been the CRR or the cash reserve ratio. This ratio, at which banks maintain cash with RBI (as a percentage of their deposits), has been hiked by 0.75%. It is meant to suck out liquidity to the tune of Rs 360 bn. The hike will, in two stages, bring the CRR from 5% currently to 5.75% by the end of February 2010.

This watershed event marks the bottoming out of the easy liquidity scenario which unfolded since late 2008. As the RBI in its own confession remarks about the divergence in inflation number at the wholesale (WPI) and consumers’ level (CPI), such a move is well understood. The widely circulated WPI number has been giving a benign impression of the trend in price rises. The rise at the consumer’s level has, however, been relatively steeper. Thereby causing change in consumption patterns.

What however, has been a concern for the RBI is the risk of cheap liquidity being channelised to risky assets and creation of bubbles. Hints from China seem to have sufficed to make RBI more proactive. The rise in CRR therefore is not only well-timed but also in sufficient measure to contain macro risks.

Coming to the challenges that the RBI foresees for the economy, fiscal deficit tops the list. The bank is also hoping for the government to phase out some of the stimuli offered to pump prime the economy. The Union Budget 2010-11 is expected to throw more light on this. Meanwhile, the RBI has raised its GDP growth projection for 2010 to 7.7%. At the same time WPI inflation estimate has been pegged at 8.5% until March 2010. More importantly the bank opines that even post the rate hikes, there will remain sufficient liquidity in the banking system. It has, however, lowered the banking sector’s credit growth projection for the current fiscal from 18% to 16% YoY.

Does the CRR hike solve the problem?

The answer is - no. The RBI believes that its monetary measures will be of little consequence unless the government mends its ways. The reversal of accommodative monetary stance cannot be effective unless there is also a roll back of government borrowing. The RBI warns that although the abrupt rise in government borrowing was managed through excess liquidity over the past two years, the same is no longer feasible.

Moreover, inflation pressures will remain and private credit demand will be stronger with the threat of crowding out becoming quite real. Thus the CRR hike is just a step in the right direction. It remains to be seen whether the government does its bit to ensure that the RBI’s purpose is met.