RBI bites the bullet, gingerly

Reverse repo rate raised to 5.25%; Sub-PLR rates may climb.

The Reserve Bank of India raised the short-term reverse repo rate by a quarter percentage point to 5.25 per cent but stopped short of a big-bang move by keeping the bank rate and the cash reserve ratio unchanged.

The repo rate, which is linked to the reverse repo rate, has also been hiked by an identical margin to 6. 25 per cent. Commercial banks park their excess liquidity at the reverse repo rate and the RBI pumps in liquidity in the system at the repo rate while the bank rate is the signalling rate.

Banks are unlikely to hike their prime lending rates (PLR) in response to the reverse repo rate hike. However, they will raise their sub-PLR rates at which corporates have been borrowing money. Union Bank Chairman Cherian Verghese said his bank would hike the sub-PLR rate by 10-50 basis points.

The bond marked heaved a sigh of relief with the bank rate being left untouched. The prices of long-term papers went up by 50-60 paise and that of medium- and short-term papers by 25-45 paise as their yield went down. The yield on the ten-year paper closed at 7.02 per cent against Monday's close of 7.16 per cent.

In its post-credit policy press conference, RBI Governor YV Reddy said, "These policy measures should see us through till the beginning of the next year barring unforeseen circumstances."

However, the policy document has made it clear that the RBI will not shy away from more such rate hikes in the future. "It is necessary to be in readiness to take further measures as warranted to meet the challenges posed by the evolving situation, given the unfolding of the risk," it said.

The trigger for the rate hike is the rising inflationary expectations. In fact, the RBI has admitted that inflation can exceed the projection of 5-5.5 per cent without a rate hike.

"Given the outlook for inflation primarily in the context of oil economy in India ... it may be difficult to contain inflation in the range of 5-5.5 per cent projected earlier without an appropriate policy response," the RBI said.

This is in sharp contrast to the finance ministry's version of inflation. Even yesterday, Finance Minister P Chidambaram had said inflation was moderate and the pass-through impact of high international oil prices seemed to be over.

The RBI's hawkishness on the inflation front has been evenly matched by its bullishness on the economy's growth momentum. It has raised its projection of GDP growth in 2005-06 from 7 per cent to 7-7.5 per cent.

It has also said that the expansion in M3 of money supply will be higher than its projection of 14.5 per cent and both deposit and credit growth will also exceed projections. In April, the RBI had projected a Rs 2,60,000-crore deposit growth and a 19 per cent credit growth for the year.

Against the backdrop of a phenomenal credit growth, the RBI has sensed asset bubbles in certain pockets like the housing sector and called for close monitoring of price rises as asset price changes can have a powerful effect on the investment climate.

The policy has also addressed some prudential and structural issues. The prudential measures include linking banks' capital market exposure to their networth instead of the asset base. The general provisioning requirement for standard assets has been raised from 0.25 per cent to 0.40 per cent.

This will require about Rs 800 crore of additional provisioning by the entire banking sector. It has also called for close supervision of banks that have significant exposure to non-banking finance companies.

Taking market reforms one step ahead, the RBI has proposed to introduce intra-day short-selling in government securities. Unhappy with the lack of transparency in setting the benchmark PLR, the RBI has asked the Indian Banks' Association to review the existing system.

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REDDY'S INFLATION FIGHTING FORMULA

Monetary tools

Reverse repo rate hiked by 25 basis points to 5.25%

Bank rate unchanged at 6%

CRR unchanged at 5%

Outlook on economy

GDP growth expectation raised to 7-7.5% from 7%

Inflation rate may exceed the projected 5-5.5%

Credit, deposits and M3 to grow higher than projected

Measures for markets & banks

Banks' aggregate capital market exposure capped at 40% of net worth

Intra-day short selling in gilts to be introduced

Infrastructure special purpose vehicles allowed to borrow abroad

Banks can issue guarantees for textile companies raising ECBs

Benchmark PLR to be reviewed

General provisioning for standard aidvances raised to 0.40% from 0.25%