Macro dynamics hint at interest rate hike

Credit growth is not showing signs of relenting.

A section of the market expects the Reserve Bank of India (RBI) to hike the reverse repo rate for the sixth time tomorrow since the monetary tightening began in October 2004.

This tightening began with the need to curb expectations of higher inflation. It subsequently continued also to contain runaway growth in credit, particularly to prevent formation of asset bubbles in sensitive sectors.

The central bank's actions so far have not had a softening impact on both inflationary expectations and credit growth. The incomplete pass-through of global oil prices coupled with a depreciating rupee are seen keeping intact the higher inflationary expectations.

All attempts at making credit dearer and slowing down the demand for loans have failed so far. After rising at a scorching pace over the last few years, credit growth is still not showing signs of relenting.

So, the market players think the RBI has no option but to increase the reverse repo rate by 25 basis points to six per cent on July 25 and have already factored a hike in bond prices.

JP Morgan in a report has said that continued strength in industrial activity, increased risk of higher inflation, torrid pace of loan growth, higher global interest rates and narrowing interest rate differential between India and the US will prompt the rate hike here.

It is highly unlikely that RBI will wait for the outcome of the US Federal Open Markets Committee's decision on the Fed rate at it meeting on August 8. The surprise rate hike in June was driven by the emergence of global factors acquiring greater weightage than before.

The RBI is likely to reiterate the significance of these factors, which have strengthened even further despite the fact that the US Federal Reserve is heading towards the end of its rate hike campaign.

"The US Fed Chairman Ben Bernanke has continually emphasised that further rate hikes would be data-dependent, a message not very well received by the market, which continues to look for hints of a (rate hike) pause in the chairman's statements," according to a July 25 policy preview of Yes Bank.

The economic data from the central bank also indicates at another rate hike. Industrial growth momentum has remained solid despite the five rate hikes.

The rise in inflation and the acceleration in money and credit growth suggest that the economy will not lose momentum in the near future.

The RBI is also expected to raise its FY07 inflation forecast of 5-5.50 per cent. The pace of bank lending continues to be surprisingly resilient, despite higher interest rates.

The growth in bank lending is still at around 31 per cent. Banks in June disbursed over Rs 50,000 crore as loans. The underlying demand for retail lending remains strong and a rate hike could be necessary to moderate its pace.

A further increase in interest rates could help moderate demand for loans in the real estate and capital markets.

The apex bank, had in April 2006, said credit to the commercial sector was expected to increase by around 20 per cent and noted that the projected growth in non-food credit implies a calibrated deceleration from a growth of above 30 per cent ruling currently.

JP Morgan, in its report, said, "the RBI is probably facing substantially less resistance from the government on hiking interest rates. To his credit, Governor Reddy has mostly stood his ground on interest rates, despite reported public differences of opinion with Finance Minister P Chidambaram."

"Now, with inflation becoming a bigger political issue for the coalition government as it attempts to project its image of being common man-friendly, Reddy should use the current ceasefire opportunistically and hike rates. For the first time since the RBI starting hiking interest rates in October 2004, financial markets expect a rate hike, and the government does not appear to be opposed to it. Indeed, Reddy should not be a spoilsport."