The rise in India’s food inflation slowed to 9.52% in the last week of February from a year earlier, touching single digit after three months. In 48 weeks since the beginning of current fiscal in April 2010, only thrice food inflation rose in single digits; and in 13 weeks the rise has been at least 20%. The wholesale price-based inflation, that dropped to 8.23% in January, is expected to drop further in February to around 7.8%.
Does this mean that the Reserve Bank of India (RBI) should press the pause button when it reviews its monetary policy on 17 March? Not too many analysts believe in this theory, but a few feel there is a slim chance that the Indian central bank may wait and watch till its 3 May policy before raising its policy rate further. RBI governor D. Subbarao’s recent public statement on supporting growth has encouraged them to think so.
I would think Subbarao’s emphasis on the “growth-inflation dynamics” is an academic statement and one should not read too much into it. He would possibly go for yet another round of rate hike—by 25 basis points (bps) each both for the repurchase, or repo, as well as reverse repo rate—this week. One basis point is one-hundredth of a percentage point.
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Repo is the rate at which RBI injects liquidity in the fund-starved banking system and reverse repo rate is the rate at which it sucks out excess liquidity. Indeed, if the Indian central bank decides in favour of a rate hike, the eighth time since March 2010, the repo rate will move to 6.75% and reverse repo rate 5.75%.
In the past one year, repo rate has gone up from 5% to 6.5% and reverse repo rate from 3.5% to 5.5%. Going by plain arithmetic, the repo rate has risen by 150 bps and reverse repo rate by 200 bps, but India’s policy rate has risen by as much as 300 bps. How?
In a liquidity-starved situation, what has been the case now, RBI infuses money and repo rate becomes the policy rate, but when there is money in the system, and RBI sucks out cash, and the reverse repo rate is the policy rate. With liquidity tightening over the past one year, RBI’s policy rate has shifted from reverse repo to repo rate.
But even a 300 bps hike is not enough since inflation continues to be higher than RBI’s revised year-end projection of 7% and it will remain at elevated levels for most part of next fiscal beginning April. High oil prices will make the inflation outlook even bleaker. In view of the state elections, the government may go slow in raising fuel prices for consumers at this point, but ultimately it will have to do so if it wants to achieve the ambitious 4.6% fiscal deficit target for 2012. This is because the budget has not made adequate provision for oil subsidies.
RBI should not worry too much about the economy losing its growth momentum now as factory output rose faster than expected at 3.7% year-on-year in January, against a revised 2.5% growth in December. This is higher than most analysts’ estimates. The important point to note is that higher credit cost (commercial banks have raised their loan rates at least twice since January) has not dampened the production of consumer goods—it rose by 11.3% by a sharp growth in consumer durables (23%) and even non-durables grew by 7% after contracting 1% in December.
If Subbarao decides to wait till May to take a call on raising rates, he may end up queering the pitch as by that time growth in inflation rate will come down further. Besides, the government’s Rs 3.43 trillion net market borrowing programme will start in April and a hike will spike the bond yield and make the cost of borrowing more expensive for the government.
Instead, RBI should go for a hike now. Indeed, it may not stop here and need to hike the policy rate further, but its timing will depend on the domestic macroeconomic scenario, international crude prices, the progress of the monsoon and the state of affairs in the Chinese economy, among other things.
The yield on 10-year government bond has dropped below 8% and a rate hike will push it up. A rise in bond yield at the end of a fiscal year is bad news for commercial banks as they need to set aside money to make good any erosion in the value of their bond portfolio. When bond yields rise, their prices drop and banks, by normal accounting practice, need to value their bond portfolio by their market price and not the price at which they were bought.
But I am told banks have nothing to worry about this as most have sold part of their bond portfolio to RBI—that need to be valued at market price—when India’s central bank was buying bonds to infuse liquidity in the system. Those bonds they plan to keep in their books till maturity do not suffer any value erosion even when their prices drop and yields rise.
The average daily cash deficit in the banking system has been around Rs 60,000 crore in March. It will probably cross Rs 1 trillion this week when Indian corporations will pay advance tax on their projected profits for the last quarter of the fiscal year, but the cash deficit will come down in the next couple of weeks as the government traditionally spends during the year-end and beginning of a new fiscal. So the system won’t choke. RBI may have to infuse liquidity later through buying bonds, but for the time being a rate hike is par for the course.
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 email@example.com