Reddy douses inflation fears

Reverse repo rate hiked by 25 basis points to 5%; Bank rate, CRR unchanged.

The Reserve Bank of India (RBI) today raised the reverse repo rate, or the short-term benchmark interest rate, by 25 basis points to 5 per cent, making it clear that the interest rate cycle had decidedly changed.

In the last credit policy in October, RBI Governor YV Reddy raised the reverse repo rate by an identical margin, signalling the beginning of a higher interest rate regime.

This is the lone monetary measure announced by the RBI's annual policy for 2005-2006, which focused on significant reforms in the debt, money, foreign exchange and commodities markets, on credit delivery and on customer services.

In tune with the United Progressive Alliance (UPA) government's common minimum programme, the policy has dealt extensively with credit delivery to agriculture and small businesses. The hike in interest rates is largely to contain inflation expectations which, said Reddy, "continues to be a high priority".

"Our inflation management is one of the best among emerging markets, he told the Press. "We have given equal emphasis to price stability and credit growth and we are committed to maintaining financial stability," he added.

The central bank has forecast that India's gross domestic product (GDP) will grow by 7 per cent in 2005-2006, in line with last year's growth rate. But for the oil shock, it would have been much higher, Reddy pointed out. The annual inflation rate has been estimated at 5-5.5 per cent during the year.

"If oil prices continue to firm up at a pace seen so far in 2005, financial markets could see a major reaction as the pace of economic activity slackens, corporate earnings fall and external imbalances sharpen," the RBI said in its statement.

In the statement, the RBI stated that its overall stance would continue to be the provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy while placing equal emphasis on price stability.

"Credit growth is the second highest in 55 years and banks should broaden their credit delivery," said Reddy.

Interest rates have already moved up, Reddy said, pointing out that yields on government securities had been on the rise since the beginning of this financial year.

"The need today is to distinguish between risk and the issues. While strong credit offtake is good, the issue is that of banks not having diversified lending," said the governor, as he expressed the need for quality credit growth, which would not destabilise the system.

The RBI maintained the status quo on administered interest rates on savings deposit accounts, non-resident Indian deposits and small loans up to Rs 2 lakh as well as on export credit.

The RBI also allowed the cancellation and re-booking of forward contracts in the foreign exchange market. It has doubled the overseas investment ceiling to 200 per cent of a corporate entity's net worth. "This signals that we support overseas acquisitions," said Reddy.

While non-bank entities will be phased out of the call money market from early August, companies will now be allowed to participate in the repo market. Further, the RBI has reduced the minimum maturity period of corporate deposits to seven days from the earlier 15. Companies have also been allowed to hedge their commodity exposure on global exchanges.

Further, the inter-bank foreign exchange market has been extended by one hour to 5:00 pm.

Furthermore, to improve trading in the government securities market, the RBI has decided to permit limited short-selling in gilts allotted in primary issues.

The policy document also focuses on depositors. The RBI is wary of banks mopping up funds through means other than the mobilisation of deposits.

The RBI is setting up an independent Banking Codes and Standards Board of India, on the lines of a similar body in the UK, to ensure that a comprehensive code of conduct for fair treatment of customers evolves and is adhered to.

The RBI proposes to come out with guidelines on mergers between non-banking finance companies and private banks. On urban cooperative banks, the RBI has started signing MoUs with state governments to ensure against systemic problems.

On the agricultural side, the RBI has set up an expert group to formulate a strategy for increasing investment in agriculture. "The thrust for rural credit will be from regional rural banks," said Reddy.

Reddy said while the RBI was optimistic about the economy's resilience, he expressed caution on global factors, especially on the oil front, which could impact the Indian economy.

India imports nearly 70 per cent of its crude oil, and the record rally in global crude oil prices has worried Indian authorities. Against the average rise of 42 per cent in global oil prices, the hike in India has been only to the tune of 17.5 per cent.

As the passthrough is not complete, the governor was sceptical of the impact this would have on oil pricing in the future, and what this would mean for the inflation rate. The annual rate of inflation based on the wholesale price index is running at 5.5 per cent.

Bank scrips take a hit

Selling pressure at bank counters weighed the markets down today. A wave of selling in bank stocks ensued after the Reserve Bank of India hiked short-term interest rates in the credit policy, brokers said.

The Bombay Stock Exchange (BSE) index for bank scrips, the BSE Bankex, was the biggest loser among BSE sectoral indices: it was down 2.49 per cent.

The benchmark BSE Sensex closed at 6,284.20 points, up 5.70 points (0.09 per cent) from its previous close.

The State Bank of India stock was the biggest loser in the Sensex basket, falling 2.58 per cent to close at Rs 604.25, followed by the ICICI Bank scrip, whose price fell 2.41 per cent to Rs 375.10. The HDFC Bank's stock fell 0.33 per cent to close at Rs 536.65.

Repo hike will not hit rates: Chidambaram

The finance ministry on Thursday said the increase in the reverse repo rate by 25 basis points was unlikely to affect bank lending rates and was a signal keep inflation under control.

"I do not think an increase in the reverse repo rate will affect lending rates. There is enough liquidity in the market. Therefore, lending rates will be benign," Finance Minister P Chidambaram told reporters after the announcement of the credit policy. Page 12

Bond market surprised

RBI Governor YV Reddy's decision to hike the reverse repo rate by 25 basis points may have surprised the bond market, but it is pretty clear from the monetary policy statement that the central bank is concerned about the potential for higher inflation, and wants to firmly nip inflationary expectations in the bud.

Prior to the policy, most market participants believed that with headline inflation headed downwards, the RBI could have postponed an increase in interest rates.

Click here for the Annual Policy Statement for the year 2005-06