This is a world war and the common enemy is inflation. In the first fortnight of June alone, central banks of Vietnam, Brazil, Indonesia and India have raised their policy rates to fight the rising inflation, while China has raised the reserve requirements for banks for the fifth time this year. The US Federal Reserve, which has cut its benchmark lending rate from 5.25% to 2% in stages since September 2007, has also dropped hints of raising rates by September and the European Central Bank has made it clear that it might hike the rate as early as next month to combat inflation.
In the Indian context, the most critical question at this juncture is: Does the latest policy rate hike, after more than a year, signal the beginning of a new rate cycle?
The economic downturn between 2000 and 2003, after the dotcom bubble burst, forced the Indian central bank to follow an easy money policy, in sync with the global surge in liquidity, and the policy rate by August 2003 came down to as low as 4.5%. Commercial banks’ reserve requirement (defined by the cash reserve ratio, or CRR) or the cash they need to keep with the central bank, also dropped to 4.5%. By October 2003, yield on the 10-year benchmark government bond pierced the 5% mark to drop to 4.94%.
The cycle reversed one year later and the first rate hike, by Reserve Bank of India governor Yaga Venugopal Reddy, took place in October 2004 when the policy rate was raised by a quarter percentage point to 4.75% and CRR, by half a percentage point, to 5%.
Reddy, who took over as the RBI governor in September 2003, did not tinker with the rates or reserve requirement in the first year. Since October 2004, when he started tightening the policy, he has raised the reverse repo (or the rate at which RBI borrows from banks) rate from 4.5% to 6% and the repo rate (the rate at which RBI lends to banks) from 6.25% to 8%.
CRR has been raised from 4.5% to 8.25% to drain excess liquidity from the system. The 10-year benchmark bond yield is now hovering around 8.35%.
Since April last year, CRR has been raised by 175 basis points to 8.25% but the two policy rates have been kept unchanged. The reverse repo rate was last raised in July 2006 and the repo rate in March 2007.
I would go with those analysts who say the latest rate hike does not signal the beginning a new cycle; rather it is the continuation of the cycle that had started in October 2004 with a one-year interlude which could have been avoided. Between 2000 and 2003, interest rates were brought down to prop up a sagging economy and in the second phase, between 2004 and 2007, rates were raised to cool down an overheated economy. Now, the growth rate has been tamed but RBI will have to ring fence the rising inflation and inflationary expectations, an offshoot of a three-hear high growth phase.
The latest rate hike is expected to be followed up with two more rounds of hike, quarter percentage point each, as well as half a percentage point raise in banks’ CRR to tighten liquidity in the financial system. Any hike in so-called repo rate, or the rate at which RBI lends money to banks, is not effective unless it is accompanied by a hike in CRR. In other words, repo rate hike can work only when the liquidity is tight and commercial banks are required to borrow from the central bank.
Unlike many other central banks, RBI has two policy rates —reverse repo and repo. It absorbs liquidity from the system at reverse repo rate and injects liquidity through repo rate. Theoretically, 6% reverse repo rate and 8% repo rate create the corridor for overnight rates. This means, overnight call money rates, or the rate of interest on money borrowed by commercial banks to tide over their temporary liquidity mismatches, should hover between the two rates.
However, in reality, this does not happen and often the overnight rates are closer to 6% than 8%. This is because there is plenty of liquidity in the system. Last year, the overnight rates even dropped to zero for a few days. In such a situation, any hike in repo rate becomes meaningless. So, either Reddy will have to keep the liquidity tight to make the repo rate become effective or go for a hike in reverse repo rate.
Why is Reddy refraining from a hike in reverse repo rate?
He does not possibly want to use it unless he is absolutely sure that the rate hike is here to stay. This is because unlike repo rate, reverse repo is positioned as a medium-term signal rate which is not used by the regulator frequently.
It could also be for convenience. Keeping the reverse repo rate at 6% gives flexibility to RBI to “manage” the rates. For instance, he can allow the system to have plenty of liquidity and bring down the effective rate despite having 8% repo rate to ensure smooth sailing of the government’s annual borrowing programme. To bridge the fiscal deficit, the government needs to raise Rs1.45 trillion from the market in 2009.
How long will the cycle continue? May not be too long. With the US Fed and the European Central Bank readying for rate hikes, and the dollar getting stronger by the day, global commodity prices will be reined in and RBI may not have to be very aggressive in tightening its policy. But another round of hike in rate as well as CRR cannot be ruled out in July, when it meets for the quarterly review of its monetary policy.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org