The Reserve Bank of India has launched an assault on inflation by increasing the cash reserve ratio (CRR) 75 basis points to 5.75 per cent. While sounding upbeat on economic growth, the central bank has kept the door open for an increase in interest rates even before the annual policy statement in April.
At a post-policy press conference RBI Governor Duvvuri Subbarao flagged inflation as the policy's main concern, stating that the central bank "struggled with price-based variables and quantity-based variables" but settled for a CRR increase as the move will anchor inflationary expectations without upsetting growth.
Borrowing a metaphor from the Mahabharata, Dr Subbarao said, "Getting out of an expansionary policy is incredibly more complex than getting in. It is like the Chakravyuh in Mahabharata you know how to get in but it is very difficult, and not many people know, how to get out."
The CRR increase will take place in two phases. In the first phase, effective from fortnight starting February 13, the proportion of deposits that banks set aside will be increased by 50 basis points. It will be followed by another 25 basis point increase effective from the fortnight starting February 27.
The two rounds will together suck out Rs 36,000 crore from the system.
The central bank is worried about food inflation spilling over into other commodities and services and the limited ammunition available to combat food prices. This was largely due to a global rise in commodity prices and the limited opportunity to import food and manage domestic prices. As a result, the projection for inflation based on wholesale price index was raised to 8.5 per cent at the end of March, 200 basis points higher than the previous estimate.
In a clear warning to markets that it could deploy a bigger arsenal to fight inflation the RBI spoke of "measures taken and to be taken by the Reserve Bank as a part of the normalisation process."
In addition it said that upside risks were also emanating from capital inflows, which had risen in recent months. So far in January, foreign institutional investors have pumped $1.58 billion (Rs 7,160 crore) into Indian equity and debt instruments.
Although the market was expecting a 50 basis point increase in CRR, RBI surprised it with an additional 25 basis point hike, which was seen as a preemptive step assuming that forex inflows will increase and create additional liquidity in the system.
Some economists expected RBI to increase the repo and the reverse repo rates, which are used to manage liquidity in the system, the central bank refrained from doing so for the moment. China, Malaysia and the Philippines moved closer to increasing rates this month and Australia and Vietnam have already done so.
Though RBI was upbeat on the growth prospects and raised the forecast for the current financial year from 6 per cent to 7.5 per cent, it also said that the economic recovery remained unbalanced and was driven largely by public expenditure.
"The higher than expected CRR hike is a clear signal of RBI's concern over inflationary trends, and has also hinted at further tightening before the next policy announcement in April. Meanwhile, the Union Budget, and the deficit numbers both fiscal and current account will also impact policy measures," said HSBC India CEO Stuart Davis.
"We maintain our forecast of a 50bp inter-meeting increase in the repo and reverse repo rates before end-March 2010, ahead of the annual policy review on 20 April," Barclays Capital said in a note.
"We have been arguing for rate hikes and would not be surprised if the process of normalising policy rates began even before the next monetary policy announcement in April," added Samiran Chakraborty Head of India Research at Standard Chartered Bank.
"We think unchanged policy rates are a 'timing' issue as the RBI has simultaneously raised its GDP estimate, its March-2010 inflation estimate, as well as stating that inflation expectations are on the rise. We maintain our view that the RBI will hike by at least 125 basis points this year with a high probability of an 'inter-policy' move post the budget," said Citigroup Global Markets India's Rohini Malkani and Anushka Shah said in a note.
Bankers said that lending rates are unlikely to increase in the immediate future but there will be some repricing of corporate loans, which have been extended at a discount to the prevailing benchmark prime lending rates of various banks. "These loans are highly mispriced. Some of that will be corrected," central banking sources said. At present, banks are offering nearly 75 per cent of their loans below the BPLR.
"By keeping interest rates unchanged, RBI has attempted to ensure that the financial sector supports the growth aspirations and remains in sync with the real economy as growth picks up momentum," SBI Chairman O P Bhatt said.
At the post-policy meeting with the RBI governor and deputy governors, a senior banker said his bank was ready to absorb a 100 basis point increase. Bankers pointed out that despite Rs 36,000 crore going out of the system, there was still sufficient liquidity in the system and demand for credit remained low.
The overall impact on bank margins is unlikely to be significant. HDFC Bank Managing Director and CEO Aditya Puri said that the bank's margins will be affected by 8 basis points. At the end of December, the bank's net interest margin was 4.3 per cent, among the best in the industry.
The domestic benchmark index Sensex of the Bombay Stock Exchange (BSE) on Friday witnessed a sharp recovery of 465 points from its intra-day low led by banking stocks. Banking stocks hogged the limelight on the bourses with the BSE Bankex ending the day as the top performer. While there was an element of short-covering, there was also relief that RBI did not raise policy rates.
"The markets were expecting a hike in key interest rates, which did not happen. The CRR increase was factored in by the market and there won't be any major impact expect in banking stocks as over Rs 30,000 crore cash will have to be deposited with RBI," said Ambreesh Baliga, vice president of equities at Karvy Stock Broking.
In the government securities market, the yield on 10-year paper moved up 3 basis points to 7.58 per cent. "It is one of those rare instances when bond yields have not moved substantially as RBI surprised the market with a more-than-expected increase in CRR," said J Moses Harding, Head Global Markets Group, IndusInd Bank.
