Mumbai: The Reserve Bank of India (RBI) raised banks’ reserve requirements to stem “unacceptably high” dollar inflows from fuelling India’s inflation but left its key policy interest rates unchanged.
Bond yield rose and shares fell as the market was not expecting a hike in banks’ cash reserve ratio (CRR).
The Bombay Stock Exchange’s benchmark index, the Sensex, fell 194.16, or 1%, to close at 19,783.51 and the yield on the 10-year benchmark paper rose by 5 basis points to 7.86%. The rupee, however, strengthened marginally to 39.3575 to a dollar amid heavy intervention by the central bank.
Defending his decision to raise banks’ CRR, the proportion of cash banks have to keep with it on deposit, by 50 basis points to 7.5%, its highest since 2001, RBI governor Yaga Venugopal Reddy said in the bank’s mid-term review of annual monetary policy statement: “Financial markets continue to experience conditions of surplus liquidity, warranting an appropriate response in order to ensure orderly market conditions.”
Reddy also recognized the risks from “the rapid escalation in asset prices—equity and real estate—driven by capital inflows”, saying: “...the biggest challenge for monetary policy is the management of capital inflows and the attendant implications for liquidity and overall stability.”
Most analysts and bankers found Reddy’s statement unexpectedly hawkish. “The CRR hike has been unexpected as we do not see too much of liquidity in the system at this point...liquidity will shrink as people tend to spend more in the festive season. Bond and equity market will wait for the signal from the US Federal Reserve that is expected to go for a 25 basis points rate cut tomorrow,” said A. Prasanna of ICICI Securites, which buys and sells government bonds.
Rohini Malkani, economist with Citigroup India, said she expects RBI to continue to use CRR in the coming months if the surge in dollar inflows continue. Foreign investors have ploughed a net $17 billion (about Rs69,480 crore) into Indian shares since January, with some $4 billion of that coming in October alone.
Analysts said RBI’s move showed it expected more inflows, which it could not counter by intervention alone. Its intervention, in which it sells rupees for dollars, has contributed to surplus cash in the domestic money market which it then drains out, or sterilizes, by issuing interest-bearing bonds. “Sterilized intervention can’t be sustained, so we should see some capital moderation measures going forward,” said Harish Menon, economist at ING Vysysa in Mumbai.
The central bank sucked out Rs3,890 crore worth of liquidity from the system on Tuesday through its reverse repo window. On Monday, it had sucked out Rs18,605 crore.
The central bank kept its key lending rate, the repo rate, at 7.75% and reverse repo rate, the rate at which it absorbs excess cash from banks, unchanged at 6%. It also left its growth forecast for the fiscal ending March 2008 unchanged at 8.5% and inflation target at 5% even though RBI has lowered the medium-term guidance to 3% from 4-4.5%.
With the latest hike, RBI has raised banks’ CRR by 2.5% since December. A 50 basis points CRR hike, to be effected from 10 November, will stamp out close to Rs15,000 crore from the system.
The hike in banks’ CRR has diminished the possibility of lending rates of commercial banks going down even though none of the banks is planning to hike rates at this point.
“In view of the CRR increase, the easing of interest rates in the banking system seems unlikely,” said Chanda Kochhar, joint managing director, ICICI Bank Ltd. Uday Kotak, vice-chairman of Kotak Mahindra Bank, too, said banks possibly would not pare their lending rates after the CRR hike.
Among public sector banks, Bank of Baroda chairman A.K. Khandelwal and Punjab National Bank chairman K.C. Chakraborty said they would not hike their lending rates following the CRR hike but deposit rates would certainly go down.
Commercial banks do not earn any interest on the cash reserve kept with RBI. Hence, with the rise in CRR, their net interest margin or the difference between their cost of deposits and earnings on loans will go down, bank analysts pointed out.
“The move is to ensure the liquidity situation doesn’t get out of control,” said Shuchita Mehta, senior economist at Standard Chartered Bank in Mumbai. According to her, inflation risks have increased significantly, even though the headline number is the lowest in five years. Without ruling out further monetary action, Mehta said: “We remain committed to the view that RBI will need to tighten reverse repo rate by 25 basis points in the first quarter of 2008.”
Robert Prior-Wandesforde of HSBC Asian Economic Team expects the wholesale price based inflation to be back above 5% by the middle of next year. “As such, we think it is still too early to suggest that rates have peaked. We are looking for a further 50 basis points CRR hike in the first quarter of next year as well one or two more repo rate increases,” Prior-Wandesforde said. “If we are right, the RBI is not going to be in for an easy ride over coming months.”
Rajeev Malik of JPMorgan Chase Bank, Singapore, however, sounds less hawkish. According to him, the latest CRR hike is mainly a liquidity management tool and not intended to give any interest rate signal. “We reiterate that policy rates have peaked, though the RBI does not appear convinced to cut policy rates anytime soon. However, a more aggressive pace of rate cuts in the US could pressure the RBI to ease early next year, in order to avoid making its job more difficult owing to widening differential between Indian and US policy rates,” Malik said.
Tushar Poddar, vice-president, Goldman Sachs, said “rate differentials vis-à-vis the US are likely to increase given our US economists’ view on the Fed cutting rates on 31 October, providing further incentives for capital inflows, and appreciation pressures on the rupee.”
Anup Roy of Mint and V. Ramakrishnan and Charlotte Cooper of Reuters contributed to this story.