Mumbai: In a bid to fight inflation, the Reserve Bank of India raised, on Tuesday, the bank balances commercial banks need to maintain with it. Called the cash reserve ratio, CRR, this is the portion of their deposits banks cannot lend out, and the central bank had increased it by half a percentage point, in two stages, to 6%. The increase reduces the amount of money banks can lend out by Rs14,000 crore.
The move will reduce the profitability of banks. In recognition of this, the American Depository Receipts (ADRs) of ICICI Bank and HDFC Bank were down sharply, and analysts expect all bank stocks to take a beating on the stock markets when they open for trading on Wednesday.
As first reported in Mint on Tuesday, the ministry of finance wants the central bank to pay interest on these reserves, something RBI is in no mood to do. The bank believes that doing this will blunt the effectiveness of CRR as a mechanism to control money supply.
On 31 January, while announcing the quarterly monetary policy, RBI governor Yaga Venugopal Reddy raised the short-term lending rate by half a percentage point to 7.5% and warned of an impending hike in CRR to fight rising inflation. India’s wholesale-price based inflation rose to 6.6% on January 17, a full percentage point higher than RBI’s projection for 2006-07, even as fears that the Indian economy was overheating began to surface.
On Tuesday, Reddy walked his talk. Interestingly, the man himself was away attending a central bankers’ meet in Hong Kong when the increase in CRR was announced by RBI.
Following the January 31 announcement, a clutch of private sector banks raised their lending rates. Public sector banks, which constitute three-quarters of India’s banking industry refrained from doing so at the request of finance minister P. Chidambaram. The minister’s request, made at a closed-door meeting in the first week of February, may have been prompted by a desire to keep India’s growth ticking. The hike in CRR, however, means that the public sector banks have no option but to increase their lending rates.
“The rise in CRR has tremendous implications. We will find it difficult to meet the demand for loans from productive sectors. We will also have to go slow in certain sectors like construction and consumer loans,” said Tara Shankar Bhattacharya, managing director of India’s largest commercial bank, State Bank of India. He also hinted at a rate hike, saying the bank’s asset-liability committee would meet soon to take stock of the situation. And IDBI Bank’s chairman V.P. Shetty told Mint that the bank would “take a call” on increasing lending rates in the next two days “depending on the cost of funds.” J&K Bank has already announced that it will increase its prime lending rate by 1%.
Consequent to the increase, the prices of bonds will fall and the yields increase. Bond dealers expect the yield on benchmark 10-year paper to cross 8% on Wednesday, from its current level of 7.92%.
“It can also impact the equity market and if growth (in the economy) slows down, which is what the central bank wants, the bull run (on the bourses) will halt,” said a Mumbai-based investment banker on condition of anonymity.
Most analysts and bankers expected the central bank to wait for the Union budget, that will be presented on February 28, before undertaking any measure to tighten money supply. “What has changed since 31 January when RBI announced its quarterly policy?” asked an irate banker who did not wish to be named.
Inflation continues to rise and a new estimate for economic growth says the country will grow at the rate of 9.2% this year on the back of 9% last year.
There is another reason for the central bank’s seeming haste: over the last week it has supported the dollar (by buying the currency) in an attempt to ensure that Indian exports do not become uncompetitive. For every dollar RBI buys, the equivalent amount of rupees flow into the system, increasing money supply and spurring inflation.
This is the second CRR hike since December, when the RBI had hiked it in two stages from 5% to 5.5%. On 17 February, the cash reserve ratio will increase from 5.5% to 5.75% and on March 3, it will increase from 5.75% to 6%.