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RBI tightens key policy rates again: What next!
September 17, 2010

The Reserve Bank of India announced its first ever mid-quarter policy review in which it hiked the Repo rate by 25 bps and Reverse Repo rate by 50 bps.


Author : Nikhil Kothari



Untitled Document

Key Points

  • Repo rate increased by 25 basis points (bps) from 5.75% to 6% with immediate effect
  • Reverse repo rate increased by 50 bps from 4.5% to 5% with immediate effect
  • Cash Reserve Ratio (CRR) has been retained at 6.0%
  • Bank rate has been retained at 6.0%
  • SLR rate has been retained at 25%
  • LAF (Liquidity Adjustment Facility) window has narrowed down to 100 bps

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The Reserve Bank of India (RBI) announced its first ever mid-quarter policy review in which it hiked the Repo rate by 25 bps from 5.75% to 6% and Reverse Repo rate by 50 bps from 4.5% to 5% with immediate effect. Repo rate is the rate at which the central bank lends to banks to infuse liquidity and Reverse Repo rate is the rate at which RBI borrows from banks to absorb liquidity as the situation demands. This action was taken in order to control inflation which has been the major concern of the Central Bank for some time now. The Reserve bank’s rate and liquidity actions since October 2009 have increased Repo rate and Reverse Repo rate by 125 bps and 175 bps respectively. Along with this, the spread between both the rates has also been narrowed down to 100 bps.

Indian economy on growth trajectory

The RBI has been quite positive on the domestic scenario since the economy is rapidly converging to its trend rate of 8-9% growth. The central bank views that the growth prospects for agriculture have been boosted by strong monsoons and expects a good Rabi harvest this time.  RBI also indicated that with higher than expected realisation on 3G and broadband wireless access auctions combined with buoyant tax revenue, the risk of fiscal deficit overshooting the target level of 5.5% for FY2010-11 is virtually eliminated. In recent months, the liquidity in the economy has moved from a situation of surplus to deficit, as a result of which banks are borrowing from RBI making the Repo rate the operative monetary policy instrument.  The transmission from policy rate to market rate has also strengthen with 40 banks have already raised their deposit rates and 26 have increased their lending rates. Overall, the RBI expects the growth to remain steady and although the inflation has stopped accelerating, the rate may still remain high for some more months.

Rate Hike to tame inflation

The expected outcome of this rate hike is to tame the inflationary pressure, a major concern for policy makers, which could come down in the next few months without impacting the growth momentum. In addition to this, the volatility in the money markets will be reduced and thereby, the monetary transmission mechanism will be strengthened. Monetary Transmission mechanism refers to the process through which changes in the monetary policy will impact the real economy. Although the Central Bank is still cautious about the global market, it expects the situation to stabilise in the coming months.

Our View on the Announcement

The RBI Mid-Quarter Policy Review was more hawkish than expected by the market. We had anticipated RBI to increase the policy rates by ~25 basis points. However, the RBI has increased the Repo rate by 25 basis points to 6.0% and the Reverse Repo rate by 50 basis points to 5.0% with immediate effect.

We expect the RBI to go in for a rate hike in the November review as well, since inflation is still a concern, although the central bank is confident of the growth trajectory of the economy. However, the immediate impact of the rate hike will be on the consumer class as banks might increase the base rate. Consequently, this will increase the cost of borrowing. An increase in the deposit rates will be a relief for savers who are as of now looking at corporate /NBFC deposits for higher returns. We expect FY2011 GDP growth to exceed 8.5% on account of good monsoon, positive growth in the industrial and services sectors and the expected revival in the global economy. However, the GDP growth of FY2012 might moderate on the back of the rate hikes being followed by the RBI in the current year.

On the back of current monetary policy, Investor who are looking to invest for 6 to 12 months can continue to invest in short term fund and those who are looking for 12 months to 18 months time horizon can look to invest in FMP’s as it seems an opportune time to lock in yield at high levels.

 


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