Yet again, the Reserve Bank of India (RBI) has raised its policy rates in an inter-meeting move. Both the repo and the reverse repo rate have been hiked by a quarter percentage point each, to 5.5% and 4%, respectively. There is an element of surprise in RBI’s action, not because the policy rates have been raised three-and-a-half weeks ahead the quarterly review on 27 July, but because of the delay in announcement of the rate hike. RBI could have done this a fortnight ago as there have been many indications that the world’s second fastest growing major economy is performing above potential.
Industrial output in April grew 17.6% over the corresponding period last year, beating analysts’ estimates by a wide margin, and coming close to the 20-year high of 17.7%, recorded in December 2009. Wholesale price-based inflation jumped to 10.2% in May, the highest since October 2008. There has been some moderation in food price inflation, but core inflation—which excludes volatile food and fuel prices—is accelerating and will inch towards 11% in June following the rise in fuel prices. The government deregulated petrol prices last month and increased prices of diesel, kerosene and cooking gas. Going by the RBI estimate, the impact of the rise in fuel prices on wholesale inflation will be around one percentage point.
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So, why did RBI wait till 2 July to hike its policy rate, that too after auctioning three tranches of government bonds to raise Rs10,000 crore? (This is quite unfair to the bidders for these bonds as they had no clue that the yields on these bonds would rise immediately and the prices would come down soon after they bought these papers. They will now need to set aside money to provide for the depreciation in the bond value. The government, however, gains as had there been a rate hike before the auction of these bonds, the prices would have been higher, raising the interest cost for the government.)
RBI’s explanation for non-action in June is the tight liquidity situation. First, in May, nine successful bidders for 3G (third-generation) spectrum had to pay Rs67,719 crore to the government. Then, in mid-June, there was an outflow of around Rs35,000 crore from the financial system on account of advance tax payments by Indian corporations; firms pay income tax every quarter on their projected profits. Finally, the government raised another Rs38,543.31 crore from the auction of broadband wireless access, or BWA, spectrum. With such a huge outflow of money from the system, banks were seen borrowing heavily from RBI’s repo window every day. They are borrowing money from RBI even now and there is no indication of easing of liquidity as yet. So the central bank possibly knows something the market doesn’t. One source of liquidity could be government spending. Once the government spends, money is released from its account kept with RBI to the financial system.
There has been some infusion of liquidity in the system, but that’s not enough. On 2 July, a government bond worth Rs15,515 crore was redeemed. Another redemption, worth Rs34,000 crore, is slated for 28 July. The central bank has bought back bonds worth about Rs9,000 crore so far, and it can buy back more to create liquidity, but even then banks will continue to borrow from the central bank through July. This means the effective policy rate will be 5.5%—the repo rate. The repo is the rate at which the Indian central bank infuses liquidity into the system (or lends money to banks) and at the reverse repo rate it drains excess liquidity. Since liquidity will remain tight, the repo rate is the anchor rate now.
It needs to be raised further to fight inflation and the central bank will probably have no choice but to go for another rate hike, maybe a quarter percentage point, on 27 July when it reviews its policy. In some sense, this is exactly what it did in March and April—a two-phase rate hike of a quarter percentage point each, one in the annual policy and another ahead of it.
Before its quarterly review in July-end, RBI will have two sets of data to analyse: wholesale inflation for June and industrial production for May. Both will justify another rate hike unless there is a dramatic deterioration in the global economic growth, triggered by the European debt crisis. The progress of the monsoon, too, will have a bearing on the decision, but not as emphatic as inflation does. The monsoon was below normal in June. If it gathers pace and turns normal by end-July, there will be a positive impact on food prices and inflation. On the contrary, if the monsoon continues to be below normal, it will threaten economic growth.
I will bet on another round of a rate hike in July-end. That will force banks to raise their base rates and make borrowing more costly for corporations and individuals. The latest round of policy rate hike will have no impact on the base rates of banks, but if RBI hikes its policy rate again in the next few weeks, the banks will have to raise their deposit rates. The year-on-year growth in bank deposits till mid-June has been only 13.9%, against 21.9% in the year-ago period. Bank credit, in contrast, has grown 19.6%, higher than 15.7% a year ago. Banks will have to pay more to mop up deposits to support the credit growth. This will also be the real test of the transmission mechanism in the financial system and the new concept of base rate that replaced the benchmark prime lending rate on 1 July.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at firstname.lastname@example.org