Mumbai: Bond prices rose and bank stocks fell on the bourses on Tuesday after India’s central bank left key policy rates unchanged in its quarterly review of the monetary policy, citing a rising risk of inflation amid global threats to economic growth and financial stability. The upside pressure on inflation, according to the Reserve Bank of India (RBI), has “become more potent and real than before.”
RBI governor Yaga Venugopal Reddy admitted “moderation” of industrial production, corporate sales and profitability, business confidence and commercial bank credit growth, but refrained from easing the policy stance as was widely expected by the market because of higher risks on the inflation front. The wholesale price-based inflation was ruling at 3.8% early January, well below RBI’s comfort level of 5%, but the central bank saw risks from rising fuel, food and metal prices.
Since October 2004 when RBI started its monetary tightening cycle, Reddy has raised the reverse repo rate, or the rate at which RBI absorbs liquidity from the system (or borrows from banks), by 125 basis points to 6% and the repo rate, or the rate at which RBI injects liquidity (or lends to banks, effectively making this a base lending rate), by 150 basis points to 7.75%. He has also raised banks’ cash reserve ratio, or CRR, which determines the balances they need to keep with the central bank, by 200 basis points since December 2006 to 7.5% to fight inflation and rein in banks’ runaway credit growth.
Reddy has not changed his stance because asset prices are rising, money supply or M3 is expanding and capital flow is growing.
The US Federal Reserve’s 175 basis points cut in policy rate since September to 3.5%, including a 75 basis points cut ahead of its policy making body Federal Open Markets Committee meeting this week, made the market believe that Reddy would bring down the interest rate in India to bridge the rate differential that encourages higher capital inflow into the country. But he preferred to give importance to domestic factors than being swayed by the threat of recession in the world’s largest economy.
According to Reddy, despite the turbulence in the global financial system, the underlying fundamentals of the economy are strong and the outlook continues to be positive. So, RBI has retained its target for growth in India’s gross domestic product at 8.5% for the fiscal year. Liquidity management is high on its agenda and it will do this “using all policy instruments at disposal” including hiking banks’ CRR and flotation of bonds under the market stabilization scheme (MSS).
This essentially means there is no change in RBI’s monetary policy stance. It has been draining liquidity from the system through the MSS bonds. It has continuously been buying dollars to check the appreciation of the Indian currency as a rising rupee pares exporters’ income in rupee terms. For every dollar that RBI buys, an equivalent amount of rupees flows into the system which is mopped up through MSS bonds. India’s foreign exchange reserves rose by $85.7 billion in the current fiscal to $284.6 billion.
Though he refrained from any rate cut, Reddy goaded Indian banks to pare their lending and deposit rates, saying they are highly profitable and their net interest margin, or the gap between the interest they pay on deposits and earn on loans, has not been affected.
M.B.N. Rao, chairman of Canara Bank, and also head of the Indian Banks’ Association, said his bank would take a call on lending rates soon, but not too many bankers share Rao’s view. Chanda Kochchar, joint managing director of ICICI Bank Ltd, India’s largest private sector lender, said banks would watch the liquidity situation for now and take a call on lending and deposit rates in the new fiscal beginning April.
Reddy’s rather hawkish tone pulled down bond prices and the yield on the benchmark 10-year bond, which dropped to 7.35% last week after the Fed’s 75 basis points cut, rose to 7.52% on Tuesday. The yield and prices of bonds move in opposite directions.
Alok Prasad, a bond dealer with Securities Trading Corp. of India Ltd, a non-banking finance firm, said the bond yield would not come down even if the US Fed cut its rate again this week as RBI “is not following the Fed move”.
Most bank stocks fell on Tuesday and public sector banks were more affected than the private ones. Shares of Bank of Baroda, Bank of India, Indian Overseas Bank and Oriental Bank of Commerce lost more than 5% each and those of State Bank of India, the nation’s largest lender, fell 3.58% to close at Rs2,225.10. The Bombay Stock Exchange’s banking industry index, Bankex, lost 3.48% even as the benchmark index Sensex, lost only 0.34%. Among private lenders, shares of ICICI Bank lost 6.37% and those of HDFC Bank Ltd 3.36%.
“A rate cut would have triggered a rally on the bond market and banks would have made money trading bonds. That has not happened,” said an analyst with a foreign brokerage.
Sandesh Kirkire, chief executive officer, Kotak Mahindra Mutual Fund, which manages more than Rs20,000 crore worth of assets, believes the policy document actually indicates a moderation in RBI’s stance and is “largely dovish to neutral”. However, not too many people share his views. A senior executive with an international brokerage, who did not wish to be identified, said: “At best, one can call it a neutral policy and there is not even an iota of bullishness in the policy.” A. Prasanna, vice-president of ICICI Securities Primary Dealership Ltd, said RBI might cut the policy rate in April when it announces its annual monetary policy if inflation remains under control.
However, a Lehman Brothers report, released immediately after the policy, said the firm expected RBI to keep its rates unchanged but hike CRR by 100 basis points by March 2009.
“Based on our current house view that the US Fed cuts rates by a further 100 basis points to 2.50% by the year-end and successfully averts a recession, we expect India to attract massive capital inflows, flooding the economy with liquidity, adding inflationary pressures and forcing RBI to hike the CRR by 100 basis points by March 2009. In this base case, we expect RBI to keep interest rates unchanged,” it said.