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RBI surprises with 0.5% hike in Reverse Repo
July 28, 2010

The Reserve Bank of India (RBI) has been very cautious in its approach to the monetary policy so that growth prospects are not affected much.


Author : Manjunath Gaddi



Untitled Document

Highlights of RBI Monetary Policy Review for first quarter of the financial year FY2010-11

  • The Bank Rate has been retained at 6.0%
  • Repo rate increased by 25 bps from 5.5% to 5.75% with immediate effect
  • Reverse repo rate increased by 50 bps from 4.0% to 4.50% with immediate effect
  • Cash Reserve Ratio (CRR) of scheduled banks has been retained at 6.0% of their net demand and time liabilities (NDTL)
  • The projection for WPI inflation for March 2011 has been raised to 6.0% from 5.5%
  • Baseline projection of real GDP growth for FY2010-11 is revised to 8.5%, up from 8.0% with an upside bias
  • M3 and non-food credit growth projections for FY2010-11 have been retained at 17% and 20% respectively
  • Mid-quarter review of Monetary Policy to be a regular event beginning from 16 September  2010 

The Reserve Bank of India (RBI) has been very cautious in its approach to the monetary policy so that the applecart of growth is not affected much.  The policy statement is in line with the market expectations, i.e., RBI announced no hike in CRR and a 25 bps (bps) increase in Repo rate but a 50 bps hike in Reverse Repo rate was not expected by many. Although RBI has increased key policy rates four times in 2010, the Reserve Bank still has the  head room to increase the policy rates even more. Chart 1 shows the hike in policy rates in 2010. We think that the central bank will take a slow and steady approach to increasing rates in the coming months. The introduction of mid-quarter policy review might be a step towards that.

The developed economies have been forced to have an accommodative monetary policy as their economies are still under recovery. Any disruptions in the developed world can have a ripple effect to the growth of India and other emerging economies. Therefore, RBI has taken a slow and steady approach to rate hikes despite inflation being in the double digits since February.

Cause and Effect 

By hiking the Reverse Repo rate, RBI has tried to lower the non-food credit off take which is currently at 22.3%. The current level of credit off take is higher than RBI’s projection of 20% for the year. The hike in Reverse Repo is 25 bps more than the hike in Repo rate. This step would lead to banks parking more money with the RBI.

Chart 1: Policy Rate Hikes in 2010
Interest rate sensitive sectors like Automobiles, Real Estate, Banking and higher risk lending sectors like Aviation and Capital Goods might face the heat going forward as inflation is expected to remain high in the short to medium-term considering the recent hike in the fuel prices.

Export dependent sectors like IT may also get affected as the Rupee may witness appreciation in the short to medium-term due to the rate hikes as well as capital inflows. RBI also anticipates large inflows into India which can lead to Rupee appreciating considerably. On 26 July 2010, Moody’s rating agency upgraded the local currency government bond rating from Ba2 to Ba1 with a positive outlook, just a notch below the investment grade rating of Baa3. This move is also expected to bring in higher inflows into the country, there by asserting an upward pressure on the Rupee.

Inflation woes

Although RBI expects the economy to grow by 8.5% in this fiscal year, the major domestic cause of worry is inflation. The fuel price deregulation and the subsequent impact on the industry are expected to add a couple of points to inflation. Thus, inflation is expected to be in double digits for the next couple of months. The RBI has also increased the projection for March 2011 from 5.5% to 6.0%, which goes to show that inflation worries may persist for the rest of the year.

Even though, currently the monsoon deficit is on the lower side, the risk of a lower monsoon can still exists. A failed monsoon or major deficit in rains in agrarian areas will lead to a double whammy effect on inflation.

Conclusion

The central bank has done a fine balancing act on its part in the monetary policy review. Most of the policy directives were in line with the market expectations except for the 50 bps hike in the Reverse Repo Rate. The higher hike in Reverse Repo will help in moderating the level of credit off take to that of RBI’s projection in the coming months. Inflation will continue to play havoc with the Indian public and policy makers alike, with some respite expected from a good monsoon. We expect RBI to also use the mid-quarter policy reviews to hike rates in the coming months so as to keep a check on inflation.


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