RBI's surprise move

It is now clear that the Reserve Bank of India's decision last Thursday evening to raise the rates at which it takes money from banks, or lends to them, was prompted by the rash of rate hikes by central banks in many countries, including the European Central Bank, and by the prospect of further interest rate hikes by the US Federal Reserve""whose new chairman flagged such a possibility in a recent speech. As RBI Governor Venugopal Reddy has clarified subsequently, his focus of attention was the international context""and this underlines the point now generally recognised, that India is fairly closely intertwined now to the global economic and financial system with all its ebbs and flows.

While it is true that such policy interventions by the central bank rarely have a single objective, Dr Reddy's clarification does put at rest speculation that the rate hike may have been prompted by concern about domestic inflation in the wake of the hike in petrol and diesel prices last week, or by the selling wave on the stock market. The stock market may have been a marginal factor, though, since foreign institutional investors would also keep an eye on possible movements in the rupee's external value: the prospect of a falling rupee (which would be logical if interest rates in India do not rise in line with increases elsewhere) may encourage exiting the Indian stock market ahead of the rupee's decline. An interest rate hike therefore would reassure foreign investors that the rupee would hold its ground, and thus serve to support the stock market. On the other hand, rising interest rates usually push down equity prices as money moves into the debt market. So the precise manner in which the stock market would respond was unpredictable. In the event, Friday saw a rally""which may also have been a corrective response to the wave of selling that went before.

Looking beyond the markets, what does the rate hike do for the economy as a whole? Since it signals a tightening of liquidity, and with banks like ICICI Bank responding quickly with rate hikes of their own, the inevitable consequence will be a slowdown in lending and borrowing and therefore a gradual slowing of the overall tempo of business. However, interest rates for most players remain in the comfort zone, especially since there is general buoyancy still in the air. Should that mood change for any reason (and the fuel price hikes are a factor here), and if interest rates climb further when the RBI does its next quarterly review in July, then there would certainly be reason to re-assess the economic growth rate this year.