RBI fights inflation, wounds borrowers

Last Updated: Tue, May 03, 2011 19:52 hrs

Repo, reverse repo rates raised by 50 basis points; Bankers expect 50-100 basis points rise in rates; Markets see red, Sensex slumps by 463 points; Central bank pegs GDP growth at 8 per cent; Savings rate to go up by 50 basis points to 4 per cent

The “baby steps” have finally given way to what Reserve Bank of India (RBI) Governor D Subbarao himself defined as a “large step”. The central bank on Tuesday raised key policy rates by 50 basis points (bps) and declared it would battle high inflation even at the cost of some economic slowdown.

This is the first time since the rate increase cycle began in March 2010 that RBI has raised operating rates by more than 25 bps. Though the move got the backing of Finance Minister Pranab Mukherjee, it left quite a few worried faces in the banking and corporate fraternity.

Heads of leading banks said a 50-100 bps increase in interest rates was certain with RBI raising repo and reverse repo rates to 7.25 per cent and 6.25 per cent, respectively. This is the ninth increase since March last year.

HDFC Bank Managing Director & CEO Aditya Puri said RBI was clearly signalling moderation in demand and banks had no way out but to increase rates by 50-100 bps. While his counterpart in ICICI Bank agreed, State Bank of India Chairman Pratip Chaudhuri was more optimistic. He pegged the rate increase at 25 bps.

And there is no respite in sight. Announcing its monetary policy on Tuesday, RBI said inflation was unlikely to come down in the near future. In fact, it predicted that things might worsen as global commodity prices were likely to remain firm. So, the consensus view in the market is that more increases are required to contain demand pressures. Analysts said they expected the rate increase season to last longer than earlier expected.

While Tushar Poddar, Chief India Economist, Goldman Sachs, saw 75 bps hikes in the future, Sonal Verma of Nomura said she expected a further 50 bps increase this year, with 25 bps each in June and July.

“Persistent high inflation undermines growth. So, if we want to sustain growth in the medium term, we need to bring down inflation. We sacrifice a little now than much more later. That is the balance of growth-inflation dynamics,” the RBI governor said after announcing the monetary policy.

Industry expressed displeasure at the steep increase. Confederation of Indian Industry Director-General Chandrajit Banerjee said this would adversely impact investment and growth. While RPG Chairman Harsh Goenka said companies might have to “alter or revisit” some plans, Ficci President Harsh Mariwala termed the continuous tightening a “little too harsh”. DLF Group Executive Director Rajeev Talwar said banks should not increase rates as they were enjoying a good spread.

The equity markets showed nervousness. The shares of rate-sensitive sectors led the fall on concerns that rising interest rates would impact sales.

While the National Stock Exchange Nifty ended at 5565.25, down 136.05 points, or 2.39 per cent, the Bombay Stock Exchange Sensex closed at 18534.69, down 463.33 points, or 2.44 per cent. All sectoral indices closed in the red.

In another significant announcement, RBI projected 8 per cent economic growth in the current financial year, lower than the finance ministry’s projection of 9 per cent. March-end inflation is seen at 6 per cent, with an upward bias.

RBI expects the measures will contain demand, which in turn will reduce pricing power. However, as the fiscal situation significantly influences demand, the government’s intention to cap petroleum and fertiliser subsidy is bound to be tested at prevailing crude oil prices. A widening fiscal deficit would counter demand moderation, RBI said.

For savers, however, there is something to cheer. They will earn 50 bps more on deposits. The savings rate, the only administered rate, has been a hindrance for monetary policy transmission.

RBI also announced a new structure of interest rates, making the repo rate, or the rate at which it lends to banks, as the single independently varying rate. All other rates will be pegged to the repo rate. The new rate structure, with the repo rate as the only independent rate, was aimed at more effective transmission of monetary policy and was in line with the global norms, analysts said. Earlier, RBI could change either its lending or borrowing rate or both.

RBI also introduced a new cash facility for banks. The rate for this would be the upper band of the rate corridor. Termed the Marginal Standing Facility, it would be priced at 100 bps above the repo rate. Under this facility, banks would be able to borrow an additional one per cent of their deposits. “This is expected to contain volatility in the overnight inter-bank market,” said RBI.

With these steps, it widened the interest rate corridor to 200 bps, with the repo rate in the middle. The reverse repo rate would be 100 bps below the repo rate and comprise the lower band of the corridor.

RBI also capped bank investments in liquid schemes of mutual funds at 10 per cent of their net worth, which comes to Rs 50,000 crore. The regulator said the rationale was to reduce the volatility in bank investments in liquid schemes.

“We have seen bank investments in these funds falling to as low as 1-2 per cent and shooting up drastically depending on the liquidity situation. Mutual funds, in turn, used to deploy the money back into banks by way of certificates of deposit. This had to be addressed as it was raising systemic concerns,” said RBI Deputy Governor Shyamala Gopinath.

This, with the penal interest on using RBI”s extra liquidity support, will reduce arbitrage opportunities for banks. In the last quarter of financial year 2010-11, banks having funds in excess of the statutory liquidity ratio of 24 per cent were using the repo facility to borrow funds and deploy in mutual funds to earn the rate differential.

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