Tamal Bandyopadhyay: Will Reddy lead or follow the market?

Domestic factors suggest a rate hike, though the external picture suggests no change is required.

In its April monetary policy, Reserve Bank of India (RBI) Governor Y V Reddy surprised the market by not hiking the interest rates. Two months later, in June, he raised its policy rates hours after the European Central Bank (ECB) hiked its key rate by a quarter percentage point to a three-year high of 2.75 per cent. The central banks in Thailand, Korea, Turkey and South Africa also hiked their key rates around the same time, while the Bank of Canada and the Reserve Bank of Australia raised their key rates between late April and early May.

The RBI move, once again, surprised and shocked the market since there was no apparent reason for such a hike with the inflation rate being well within the RBI target. In fact, there were instances earlier when there were concerns on the domestic front but the Indian central bank refrained from any rate hike. For instance, in August 2003, WPI inflation shot up to 8.7 per cent. Despite this, the RBI preferred to wait till its mid-year review of the monetary policy in October to hike the reverse repo rate "" the rate at which the RBI sucks out excess liquidity from the financial system "" by a quarter percentage point to 4.75 per cent. By that time, the inflation rate had dropped to about 7 per cent. In September 2005 too, when the government hiked oil prices, the RBI did not act and waited till its mid-year review of the monetary policy in October to raise the reverse repo rate by a quarter percentage point to 5.25 per cent. It showed no urgency to combat the rising inflationary expectations in the aftermath of the oil price hike.

These instances point to a critical shift in the RBI's monetary policy stance: In its scheme of things, the external developments now have a larger say than the events on the domestic turf. In fact, while announcing the April monetary policy, Reddy had said: "In a situation of generalised tightening of monetary policy, India cannot afford to stay out of step. It is necessary, therefore, to [not only] keep in view the dominance of domestic factors as in the past, but [also] to assign more weight to global factors than before, while formulating the policy stance." If he sticks to this stance, one can expect maintenance of status quo when the central bank announces its mid-year review of the monetary policy next week.

This is because the US policy rate has peaked and some of the members of the Federal Open Market Committee (FOMC), the policy-making body of the US Federal Reserve, have started talking about reduction in rates to pep up the economy which has been showing signs of a slowdown. The ECB has recently tightened its policy with a quarter percentage point increase of its benchmark rate to 3.25 per cent, but the Japanese central bank has refrained from another rate hike after settling for a quarter percentage rate, ending the four-year-old zero rate regime.

Clearly, there is no external pressure on the RBI to hike its policy rates at this juncture. It also does not need to protect the local currency from slipping against the greenback as the rupee is holding rock steady and the market players do not need any extra incentive in the form of a hike in domestic interest rates to build assets in local currency. However, if Reddy decides to give more weightage to domestic factors, then there is a case for a rate hike.

He has hiked the reverse repo rate by one and a half percentage points in six stages between October 2004 and July 2006 to 6 per cent. After an out-of-turn hike in June, he did it again in July during the quarterly review of the policy, the third hike since January this year. Besides, the RBI has also aggressively been pursuing sector-specific approach to curb the phenomenal loan growth. It has raised the provisioning requirement on standard assets in certain categories of loans as well as the risk weight on commercial real estates loans for capital adequacy purposes.

The WPI-based inflation has crossed the 5 per cent mark to touch 5.16 per cent this month and it is expected to rise further. The RBI's inflation target for the year is 5-5.5 per cent but Finance Minister P Chidambaram has recently indicated that the inflation tolerance level has dropped to 4 per cent. GDP grew at 8.9 per cent in the first quarter of 2006-07, after a 9.3 per cent increase in the previous quarter ended March 31. The growth in credit continues to be very high despite a slowdown in certain segments. The year-on-year growth in bank credit till September-end has been 29.7 per cent against 35.9 per cent a year earlier. The incremental credit growth has been Rs 3,78,498 crore on September 29, much higher than the Rs 3,36,333 crore a year earlier. Finally, there are also concerns over high growth in money supply (M3). The year-on-year M3 growth, on September 29, was at a high of 18.5 per cent, on top of 17.4 per cent a year earlier. The RBI's target for M3 growth for 2006-07 is 15 per cent.

The US Fed outlook on interest rates and falling crude prices are indeed zones of comfort for the RBI at this point of time. However, if the central bank overlooks the domestic factors and decides to press the pause button now, it may have to hike the rate in January when the next quarterly review of the policy is due. It is up to Reddy "" whether he would like to lead the market and OPT for a quarter percentage point rate hike or remain passive and be led by the market.