Mumbai: The Reserve Bank of India (RBI) on Tuesday increased key policy rates by 25 basis points (bps) to tame inflationary expectations, sustain economic growth momentum and accommodate the government’s borrowing plan.

It raised the repo rate—at which it lends to commercial banks—by 25 bps to 5.25% and the reverse repo rate—at which banks park excess cash with the central bank—by the same amount to 3.75%. RBI also increased the cash reserve ratio (CRR), the portion of deposits banks need to keep with the central bank, by 25 bps. One basis point is one-hundredth of a percentage point.

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The CRR increase will take effect on 24 April and absorb Rs12,500 crore of excess cash from the banking system.

“There will be no immediate impact on interest rates as there is adequate liquidity in the system. For the next two to three months there will not be any increase in rates," said Keki Mistry, vice-chairman and chief executive officer, Housing Development Finance Corp. Ltd. “It is possible that the Reserve Bank of India could hike CRR by another 25 basis points prior to the next policy review" due in July.

The hike in policy rates was in line with market expectations or in some cases, lower than what the Street anticipated. The benchmark Bombay Stock Exchange (BSE) sensitive index (Sensex) snapped a five-day losing streak, closing 59.9 points, or 0.34%, up at 17,460.58.

Stocks of rate-sensitive sectors rebounded. Real estate was the biggest gainer with the BSE realty index gaining 3.08%. It was followed by the Bankex with 1.53%, while the auto sector index gained 1.19%. The yield on the 10-year benchmark bond eased to 7.98% after the RBI announcement, its lowest since 13 April; it ended the day at 8% against its previous close of 8.05%. “Developments on the inflation front are worrisome," RBI governor D. Subbarao said, adding that pressure was spreading from food to other areas of the economy, prompting the increase in rates.

Graphic: Ahmed Raza Khan/Mint

Wholesale price-based inflation touched a 17-month high of 9.9% in March. RBI expects inflation to come down to 5.5% by this fiscal-end.

Despite inflation worries, the central bank is optimistic on the growth front, pegging its forecast for 2010-11 at 8% with an upward bias. Gross domestic product (GDP) growth for the last fiscal year is estimated in the range of 7.2-7.5%.

RBI’s 2010-11 growth expectations are based on the fact that India’s exports have been growing and industrial sector recovery has become more broad-based.

“The RBI appears comfortable on sustained growth given the uptrend in exports, broad-based industrial recovery, uptick in services and improved corporate profitability," said Rohini Malkani, economist, Citi India. “Citi maintains its view of a minimum additional 75 basis points hike in 2010, with a possibility of an inter policy hike before its 27 July meeting."

Subbarao also gave himself room for such a move.

“It looks like we have to move many times... I will not rule out a mid-cycle action," he said. “We will think many times before we take mid-cycle action."

Rupa Rege-Nitsure, chief economist, Bank of Baroda, said medium-term inflation could accentuate the risks to growth. “The Reserve Bank of India is lagging behind the curve. A 25 basis points increase is very mild, it must have acted in the interest of stability of financial markets," Rege-Nitsure said. “The uncertainties will only increase going further as monsoon patterns are unpredictable and with government not introducing any oil reforms (it) could further aggravate inflation pressures. Inflation will hover in the range of 10-11% till June. However, it could ease off from July on account of the base effect and new rabi crop.“

Shubhada Rao, chief economist, Yes Bank Ltd, said: “The monsoon outlook will be a critical input for shaping the growth and inflation outlook and an important determinant of further timing of monetary action. For fiscal 2011, we expect GDP growth at 8.5% and average annual inflation at 6%."

Bankers say that while the policy will have no immediate impact on lending rates, there is an upward bias on them.

Demand and supply will decide interest rates, said O.P. Bhatt, chairman, State Bank of India (SBI). “There is an upward bias on rates. The daily calculation of interest rates on saving deposits has had a 16 bps impact on our cost of funds," he said. “Liquidity is going down with the CRR hike."

Chanda Kochhar, managing director and CEO, ICICI Bank Ltd, said: “There will be an upward bias on interest rates as credit demand picks up. Credit demand normally picks up in the second quarter."

Most of India’s large banks have recorded at least 20% growth in credit in the fiscal year to March, signalling economic revival and growing corporate confidence in fresh investments for capacity expansion, the central bank has said. Credit growth has expanded steadily during the second half of the year from its intra-year low of 10.3% in October 2009 to 16.9% by March 2010. The central bank has pegged credit and deposit growth at 20% and 18%, respectively.

Rana Kapoor, managing director and CEO of Yes Bank, said: “The 25 basis points hike is optimal for the economy to absorb and ensure sustainable growth. A sharp increase in rates would dampen the investment multiplier."

To ensure continuity of bank finance to the productive sector, in particular the infrastructure sector that needs about $500 billion (Rs22.3 trillion) by 2012, RBI has proposed to allow banks to classify their investments in non-SLR (statutory liquidity ratio) bonds issued by companies engaged in infrastructure activities and having a minimum residual maturity of seven years under the held-to-maturity category.

This is being done as the long-term bonds issued by companies engaged in infrastructure activities are generally held by banks for a long period and not traded and also with a view to incentivizing banks to invest in such bonds.

Additionally, it has also reduced the provisioning requirement for infrastructure loan accounts classified as substandard to 15% from 20%.

RBI proposes to set up a working group with representatives from the government, the Securities and Exchange Board of India, the Insurance Regulatory and Development Authority and the Indian Banks’ Association to recommend a road map for the introduction of a holding company structure together with the required legislative amendment.

In 2007, commercial banks, including ICICI Bank and SBI, had proposed to float holding companies for their insurance and mutual fund businesses. This did not find favour with RBI on account of lack of clarity in the existing statutes relating to the regulation and supervision of financial holding companies.