Reddy pointed out, at a function to facilitate the Bank of Mauritius Governor, that the wide gap between the policy rates - repo and reverse repo - was the result of monetary operations and not a predetermined decision.

While the market stabilisation scheme (MSS) is performing well as a liquidity management tool, the additional bills towards liquidity absorption increased the government's burden and affected the fiscal deficit target mandated by the Fiscal Responsibility and Budget Management (FRBM) Act, banking analysts said.

The market stabilisation scheme (MSS) is a liquidity absorption mechanism adopted by the RBI and involves the issuance of treasury bills and bonds to suck out liquidity from the system.

The scheme has become an embarrassment for policy makers as the MSS target of Rs 250,000 crore (Rs 2500 billion) exceeded government borrowings of around Rs 1,11,196 crore (Rs 1111.96 billion).

The government's liquidity management function has gone beyond actual borrowing to meeting expenditure needs. The government is absorbing funds to manage liquidity and compensating by making coupon payments on treasury bills and bonds issued under MSS rather than borrowing for planned expenditure.

In essence, analysts said, in order to meet the FRBM target of reducing fiscal deficit to 3 per cent of GDP by the end of next financial year and managing inflation, the government may have to sacrifice public welfare expenditure if inflows continue to pose threat.

The repo and reverse repo are two liquidity adjustment facility tools through which the RBI manages daily liquidity. The central bank absorbs liquidity through reverse repo and infuses liquidity through the repo route.

The repo rate is 7.75 per cent and reverse repo is 6 per cent currently, resulting in a corridor of 175 basis points. While there is nothing sacrosanct about the gap between the repo and reverse repo rate, it was comfortably maintained at 100 basis points. One basis point is one hundredth of a percentage point.

Reddy further stated that during uncertain times such as the deluge of foreign exchange inflows last year, all stakeholders in the financial system - banks, the government and the central bank - need to pay an uncertainty premium.