Continuing its fight against rising inflation in a $1.2 trillion (Rs56.04 trillion) economy that is set to expand at least 8.5% in the current fiscal, the Reserve Bank of India (RBI) on Tuesday raised its policy rates, but there is a tactical change in its move. Instead of raising both its policy rates by an identical margin, as has been the case since it started the rate tightening cycle this year, the central bank has raised its repo rate by 25 basis points (bps) to 5.75% and reverse repo rate by 50 bps to 4.5%. One basis point is one-hundredth of a percentage point.
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The repo rate is the rate at which RBI infuses liquidity into the system when commercial banks want money from the central bank, and the reverse repo rate is the rate at which the central bank drains cash when banks have excess money. So, in a liquidity-flush situation, the reverse repo is the policy rate, but when there is no excess money in the system and banks are borrowing from RBI, as has been the case for past two months, the repo rate is the policy rate.
This means the policy rate is now 5.75%, but RBI doesn’t want a sharp drop in the rate if the liquidity returns to the system even for a few days, say, on account of a sudden spurt in government spending or redemption of government bonds. When such things happen, the policy rate will drop to 4.5%. Had RBI gone for a 25 bps hike in both the rates, the drop would have been much sharper: 4.25%. This would have increased volatility in interest rates.
While a narrower rate corridor will dampen this volatility, the Indian central bank is emphatic that it will not allow excess liquidity in the system as that will dilute the effectiveness of policy rates. In other words, if needed, RBI will follow up its rate hike with a rise in banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with the central bank. Currently, CRR is pegged at 6% and the last time it was raised was in April. A hike in CRR drains liquidity as banks are left with less money to lend. RBI will use this monetary tool to keep the policy rate at the higher end.
Unlike many other central banks across the globe, RBI has two policy rates, and they need to be seen in the context of how much money is in the system. Normally, the Indian central bank talks about “adequate” and “appropriate” liquidity to take care of the credit need of companies and individuals in a growing economy, but this time it explicitly said it will keep the system dry to make its policy rates effective and fight inflation.
From this standpoint, this is possibly the most hawkish policy that RBI has unveiled since July 2008, when both the repo rate as well as CRR were raised to 9% each to fight rising inflation and signs of overheating in some parts of the economy.
The markets do not seem to have appreciated the gravity of the policy announcements, yet. Bond prices dropped and yields rose, but there was no dramatic movements. For instance, the yield on the 10-year benchmark bond rose marginally from 7.67% to 7.72%. There was no impact at all on the equity market and the bellwether Sensex, the Bombay Stock Exchange’s sensitive index, rose 0.32%. None of the rate-sensitive stocks was under selling pressure. In fact, the exchange’s real estate and auto indices rose by 1.47% and 2.44%, respectively. Typically, when interest rates rise, sales in automobiles and real estate slow as many consumers stop taking bank loans.
The reason behind this could be banks’ unwillingness to raise their loan rates. Till the latest round of rate hikes, both the repo as well as the reverse repo rates had risen by 75 bps each, but none of the banks had raised their loan rates. Even after this hike, they do not seem to be in a hurry to raise their loan rates. This is surprising, because the year-on-year loan growth is already 21.7%, but the growth in deposits has been tardy at 14.9%. The banks will have no choice but to raise their deposit rates, as otherwise they will not have enough money to support their loan growth. Once the deposit rates are raised, they will have to hike their loan rates. It’s a matter of time before they officially do that. Meanwhile, they may raise the loan rates selectively for some sectors without changing their base rate. This can be done by raising the risk premium for certain sectors such as real estate.
Wiser with experience, RBI has now decided to review its monetary policy every six weeks. This will spare the central bank from making inter-meeting policy announcements as it did in June and April.
Till 2005, RBI used to make two formal policy statements— in April and October—known as the slack season and busy season policies. Former RBI governor Y.V. Reddy introduced quarterly reviews of monetary policy in fiscal 2006.
Globally, most central banks conduct a monthly policy review and a few of them, including the US Federal Reserve, six-weekly ones. The Federal Open Market Committee, the policymaking body of the Fed, holds eight meetings every year at intervals of five to eight weeks.
Bank of England’s Monetary Policy Committee meets every month to set interest rates. The European Central Bank, whose main objective is to maintain price stability, too, makes its rate decision once a month. Both the Australian central bank as well as the Bank of Japan make monthly announcements on rates.
RBI was resisting shifting to a six-weekly policy regime because of lack of adequate data to track economic activities. It bases its assessment of the economic scenario on data related to inflation (both retail and wholesale), exports, imports and industrial production. All these figures are released monthly, while data on the gross domestic product (GDP) is released every quarter. Then there are other monthly data such as sales of automobiles, cement despatches and airline passenger traffic. RBI also has its own database on the level of business confidence, household sector’s inflation expectations and growth in GDP.
So even though it does not have access to retail sales, inventories of manufacturing firms and employment data like its counterparts in developed economies, RBI can review the monetary policy every six weeks.
Decoupled monetary policy
Till the 2008 global financial crisis, RBI used to take its cue from the Fed on rate actions with a lag. It could not afford to have an interest rate that was out of sync with that of the US, as a higher rate in India would have encouraged more capital flow and vice versa. But this has changed. In fact, recent moves by the Asian central banks have made it abundantly clear that the European debt crisis will not have any impact on the Asian growth story and that, at the least, the monetary policy of the two groups has decoupled.
In the past one month, the central banks of Taiwan, Malaysia, South Korea and India have raised interest rates, with RBI doing it twice to rein in inflation, as their economies are on the firm path to recovery. The Australian central bank was the first to hike its policy rate this year and India followed suit.
Among the Group of Seven nations, Canada is the only country that has hiked its rate— twice in recent months—as its economy is showing signs of significant strength, but the central banks of the US and the UK and the European Central Bank have been holding on to their rates for years now.
In its July update of the World Economic Outlook, the International Monetary Fund (IMF) raised its global growth projection for 2010 to 4.6% from its April projection of 4.2%, but this is driven by its optimism about emerging market economies. In India, the recovery has consolidated and is increasingly becoming broad-based. Even if the Europe debt crisis escalates and the US recovery continues to be constrained by high employment and modest income growth, domestic demand will drive India’s economy.
RBI has raised its growth projection from 8% to 8.5%. This is more conservative than IMF’s 9.4% growth projection for calendar year 2010, but even when the economy is growing at 8.5% and inflation is in the double digits, a 5.75% policy rate is too low. So expect more hikes in the coming months. And CRR, too, may be raised to make the rate effective.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Comments are welcome at firstname.lastname@example.org