RBI, markets take global cue

Repo, reverse repo up 25 bps.

In April, Reserve Bank of India (RBI) Governor YV Reddy surprised the market by not hiking interest rates while announcing the central bank's annual monetary policy. Today, he did an encore by hiking rates.

After the close of market hours, the RBI hiked the reverse repo rate by 25 basis points (one basis point is one-hundredth of a percentage point) to 5.75 per cent with immediate effect.

The repo rate too was hiked by an identical margin to 6.75 per cent. The RBI sucks out liquidity from the financial system daily through its reverse repo window and infuses liquidity through its repo window. It left the bank rate, its main rate signalling device, untouched at 6 per cent.

Even though Reddy had earlier warned that he could hike the rates any time and would not even need to wait for the quarterly review of the monetary policy in July, the move took the market by surprise.

"We did not expect this at a time when the stock market is in free fall. The rate hike will dampen the growth prospects of the economy and add to bearish sentiment," said an investment banker.

The immediate provocation for the rate hike was the rise in global interest rates. The European Central Bank (ECB) today hiked its key rate by 25 basis points to a three-year high of 2.75 per cent.

The ECB, which had last hiked its rate in March, also sounded a hawkish note, stating that it would move again if its economic outlook was confirmed. The central banks of Thailand and Korea too hiked their rates by an identical margin to 5 per cent and 4.25 per cent, respectively.

The South African central bank had hiked its rate by 50 basis points to 7.5 per cent yesterday. The US Federal Reserve, which hiked its rate by 25 basis points to 5 per cent last month, is slated to take a call on the future movement of rates on June 28-29.

A terse RBI release today said the decision to hike the two key rates was taken "on a review of current macroeconomic and overall monetary conditions".

Apart from being in sync with the global interest rate scenario, bankers are seeing twin objectives behind the rate hike "" controlling inflation expectations and protecting the rupee.

The wholesale price index-based inflation rate climbed to 4.75 per cent from 4.32 per cent for the week ending May 20.

The recent hike in oil prices will have a 40-basis-point impact on the inflation rate. This means it will breach the 5 per cent mark. The RBI has projected a 5-5.5 per cent range for the inflation rate in 2006-07.

The rupee breached the 46 level vis-a-vis the dollar for two consecutive days but closed at 45.95, thanks to the tacit intervention by the central bank through a few public sector banks.

The hike in domestic rates will encourage market players to build rupee assets and ring-fence the currency against any speculative attack.

The inflation control exercise has also been triggered by the surplus liquidity in the system. The RBI is absorbing around Rs 55,000-60,000 crore from the market daily through its reverse repo window. The money supply on May 12 on a year-on-year basis stood at 18 per cent, as against 14 per cent last year.

In its April policy, the RBI had said: "In a situation of generalised tightening of monetary policy, India cannot afford to stay out of step. It is necessary, therefore, to keep in view the dominance of domestic factors as in the past but to assign more weight to global factors while formulating the policy stance."

Reddy clearly stated that the central bank would be ready "to act in a timely and prompt manner on any signs of evolving circumstances impinging on inflation expectations."