There was no surprise in the Reserve Bank of India’s (RBI) decision to hike key policy rates in its first six-weekly monetary policy review to fight inflation in Asia’s third largest economy. The repo rate, at which RBI infuses liquidity in the system, has been raised by 25 basis points (bps) to 6% and the reverse repo rate, at which the Indian central bank drains excess liquidity, by 50 bps, to 5%. One basis point is one-hundredth of a percentage point.
One should not read too much into the 50 bps hike in the reverse repo rate. The effective policy rate now is the repo rate as banks do not have enough liquidity and they are borrowing from RBI. But the real surprise was the behaviour of bank stocks on Dalal Street. They celebrated the rate hike. Shares of eight of the 14 banks that constitute the Bombay Stock Exchange’s banking sector index, Bankex, rose, and the index was the second highest gainer on Thursday, even as the Sensex, the exchange’s bellwether equity index, lost 0.43%.
Theoretically, a hike in policy rate affects banks and other interest rate sensitive stocks such as automobiles and real estate as the rise in the cost of funds dampens the spirit of home and car buyers. Bank stocks get affected as a hike in the policy rate pushes up the bond yield and erodes the value of banks’ securities portfolio, forcing them to book mark-to-market (MTM) losses. MTM is an accounting practice of valuing an investment in accordance with its current market price and not the price at which the investment was made. Besides, the RBI statement made it clear that banks must raise deposit rates to make them attractive.
Currently, the return on deposits is negative and, hence, there has been a sharp drop in bank deposit growth. In absolute terms, in the first five months of the current fiscal, up to 27 August, the deposit portfolio has risen by Rs 1.77 trillion against Rs 2.47 trillion last year. Once banks hike deposit rates, the cost of money rises and the net interest margin, or the gap between what they spend in raising money and what they earn by giving loans, shrinks, affecting profitability.
Then why did bank stocks rise? There is a subtle change in RBI’s monetary policy stance: the bias has shifted from tightening policy rates to reaching a neutral zone. Or, one can say that RBI has reached a near-normal zone and from now on it may or may not tighten policy, depending on macroeconomic indicators such as inflation, factory output, trade data, money supply, credit and deposits, etc.
Between March and now, RBI was driven by one objective— raise policy rates and sprint towards the normal zone as economic recovery strengthened. In the process, the repo rate has risen by 125 bps and the reverse repo rate 175 bps. Despite that, both of them are much lower than what they were before the global credit crunch. The repo rate at that time was 9% and the reverse repo rate 6%.
But they do not need to go up to that extent to achieve normalcy. With the latest round of rate increases, the monetary situation is “close to normal” and “the role of normalization as a motivation for further actions” is likely to be “less important”, RBI says. One cannot expect the central bank to be more explicit to demonstrate the shift in bias.
Does this mean that RBI is done with its rate-tightening cycle? Certainly not, but from now on, such an action will not be predetermined as has been the case since April, with visible signs of economic recovery. The RBI statement says the “process is still incomplete”, and emphasizes the “need for continued policy response to contain inflation and anchor inflationary expectations”.
The wholesale price-based inflation in August dropped to 8.5% from 9.8% in July after a change in the base year. Inflation has reached its peak, but will continue to remain at “an unacceptably high level” for a few more months before coming down. This is indeed a cause for worry, but the factory output that grew 13.8% in July, significantly higher than estimates, may not continue to remain at such an elevated level. The growth in money supply, or M3, has been 15.1% this year, below the RBI estimate, and much lower than last year’s growth of 19.9%. Similarly, credit growth in the first five months of the current fiscal, in absolute terms, has been Rs 1.08 trillion, but if one takes into account the money raised by telecom firms for third-generation spectrum and broadband wireless access licences, it will be less than last year’s credit growth of Rs 28,000 crore. Export growth dropped sharply in July and may not see a significant upturn as the recovery in developed economies is slowing. All these indicators will determine whether RBI will go for a rate hike in November in its mid-year policy review.
There was no dramatic rise in bond yields on Thursday, but the rate increase will raise the average cost of funds for banks, making money more expensive for borrowers. The shrinkage in the rate corridor also indicates RBI’s willingness to move towards a single operating policy. This will help RBI transmit its policy signal faster and leave little room for interpretation. One can argue that a central bank cannot lend and borrow from banks at the same rate, but then RBI doesn’t need to infuse money through its repo window. For instance, it can buy bonds or conduct open market operations. These technicalities won’t come in the way if RBI wants to shift to a single policy rate.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email comments to firstname.lastname@example.org