CRR hike not to hit interest rates

Cash reserve ratio at 7%; Reverse repo cap lifted.

Banks' lending rates will remain largely untouched by the Reserve Bank of India's (RBI's) decision today to raise the cash reserve ratio (CRR).

However, banks are likely to stop giving short-term loans at discounted rates with part of the liquidity being withdrawn by the RBI in its first-quarter review of the 2007-08 monetary policy.

Banks also began partially correcting peak rates offered on one-year deposits after the RBI kept reverse repo and repo rates unchanged for the second time.

Canara Bank, Bank of Baroda and Bank of India announced an interest rate reduction on their special one-year deposit schemes by 50 basis points to 9 per cent today.

The increase in CRR, the cash balances banks are required to keep with the central bank, by 50 basis points to 7 per cent from August 4 will drain Rs 16,000 crore.

Unlike earlier occasions, the current CRR hike did not trigger lending rate increases as banks will be flush with liquidity even after the outflow. This is the fourth identical increase in CRR since December 2006 and it absorbs only a part of the excess liquidity.

"The actions taken are liquidity management issues and not interest rate signals. Interest rates will remain unchanged," said KC Chakrabarty, chairman of Punjab National Bank, the country's fourth-largest bank.

Addressing a press conference, RBI Governor YV Reddy said, "There is still a fear of high inflation." This despite the fact that inflation was at 4.41 per cent last week, well below the central bank's target for this year of 5 per cent, after it crossed 6 per cent in January.

The RBI also removed a Rs 3,000-crore limit, imposed in March, on the amount it absorbs through reverse repo auctions. Reverse repo is an instrument by which the central bank absorbs money from banks against government securities normally for a day.

This measure is expected to lift the overnight call money rates from the sub-1 per cent levels prevailing for over two months. The limit had spurred banks with spare cash to lend more in the money market.

The equity markets jumped 290 points (see adjoining story) and bond yields went up after the policy was announced as bond prices fell on expectation of lower demand. Bond prices and yields have an inverse relationship. The yield on the 10-year bond rose 8 basis points to 7.85 per cent.

The RBI said the liquidity overhang on July 27 was Rs 72,823 crore, still significantly below Rs 97,449 crore in March. The glut has been caused by large overseas capital inflows and high government spending.

The RBI has also expressed concerns about the activities of hedge funds and private equity funds in the backdrop of the global credit squeeze because of the sub-prime housing crisis beginning to hit the regular mortgage market.

CAUSE AND EFFECT
(Impact of Q1 review of 2007-08 monetary policy)

Measure Calls for more active management of capital flows to contain inflation within the 5% target

Impact: Suggests tightening of overseas borrowings and liberalisation of capital outflows

Measure: Cap on reverse repo liquidity absorptions removed; second reverse repo withdrawn from August 6

Impact: This will push overnight call money rate higher from below 1%

Measure: CRR raised by 50 basis points to 7% from August 4

Impact: Will drain Rs 16,000 crore of liquidity from the banking system

Measure: Repo/Reverse repo rates kept unchanged

Impact: Interest rates will stay at current levels
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