On March 19, the Reserve Bank of India raised the two policy interest rates — the repo and the reverse repo rates — by an identical 0.25 percentage point. The repo rate, the rate at, which banks borrow from the central bank, is now 5 per cent while the reverse repo rate, the rate at which banks deposit their surplus with the central bank, is 3.50 per cent.
The RBI had, in its third quarter review of the monetary policy (January 28, 2010), hiked the cash reserve ratio by 0.75 percentage point to 5.75 per cent. The CRR acts by impounding liquidity by an estimated Rs.36,000 crore in January alone. Its ability to influence interest rates is indirect.
In contrast, the repo and reverse repo rates are overt interest rates signalling devices. But whether banks will heed these signals and mark up their commercial lending rates is another issue.
Some top executives of banks have said that they would wait and watch. Notwithstanding the CRR hike of January, liquidity continues to be abundant. At the same time, credit growth is not as robust as required to support the higher growth trajectory. Higher interest rates may discourage potential borrowers.
The markets might have been caught unawares but the RBI action is entirely consistent with its recent monetary policy stance. The policy rate changes have been announced days before March 31, the date on which banks close their accounts. Higher interest rates will have substantial implications for banks' balance sheets, especially their holdings of bonds and fixed income securities.
Another reason why new interest rate signals were not expected arose from the belief that the RBI would hold its hands till the annual credit policy statement for 2010-11 scheduled for April 20. Indeed, after the January policy announcement, some senior RBI officials were quoted as saying as much. But the policy statement itself had not ruled out RBI action.
In fact, in January, there was an unambiguous stress on combating inflation and anchoring inflation expectations.
Anyway, the practice of making changes in repo rates and CRR independent of policy announcements has been fairly common in the recent past. The RBI revised its target for inflation for March 31, 2010, to 8.5 per cent from 6.5 per cent earlier. Quite significantly it marked up its growth forecast to 7.5 per cent for the year, substantially higher than its earlier forecast of 6 per cent with an upward bias. Even this revised forecast is considered conservative given that other official and non-official forecasts have been even higher.
Rationale behind action
The RBI attributes its action in hiking repo rates to the significant macroeconomic developments since the third quarter review (January 2010). On the one side, recovery is taking hold. The manufacturing sector has been experiencing robust growth. The sharp acceleration in the growth of the capital goods sector points to a revival in investment activity. Exports have started growing since November 2009 after contracting for 13 straight months. There is a sustained rise in non-food credit and corporates have been tapping non-bank sources as well. What is significant is that growth in India is being driven predominantly by domestic factors.
Inflation remains high
Encouraging as these growth signs are, they have to be viewed alongside the resurgent inflation. Food inflation, though lower than in previous weeks, was still at a high 17.81 per cent in the first week of March. For February, the WPI inflation at 9.89 per cent was moving into double digits. It is also considerably more than the RBI's baseline projection of 8.5 per cent for March 2010. Consumer price inflation, as measured by various consumer price indices, remains at elevated levels.
There is enough evidence to show that food inflation is spilling over into the wider inflationary process. This is seen by the sharp increase in the non-food WPI inflation recently. Year-on-year non-food manufacturing products inflation (with a weight of 52.2 per cent) which was negative (-0.4 per cent) in November 2009 turned marginally positive in December and rose sharply thereafter touching 2.8 per cent in January 2010 and further to 4.3 per cent in February 2010. A similar pattern has been seen in the year-on-year fuel price inflation.
With rising demand there is a risk that WPI inflation might move into double digits in March 2010. Recent industrial production data suggest revival of private demand, which could add to inflationary pressures.
In the final analysis, the RBI feels that it is preferable to take pre-emptive action even if it is outside the policy reviews rather than take stronger action when inflationary expectations have accentuated. The other important dimension to the policy moves is to be seen in the context of a withdrawal from the cheap monetary policy.
According to the RBI, the low policy rates that existed before the recent hikes are more characteristic of a crisis situation than of an economy showing robust growth. The hikes in repo rates are part of a calibrated exit strategy initiated in the second quarter review (October 2009) and carried forward in the January third quarter review.