Tamal Bandyopadhyay: No surprises here

If Mint Road were a human being, it would have smiled on Tuesday hearing the collective sigh of relief from bond dealers after the Reserve Bank of India (RBI) announced its decision to hike the short-term reverse repo rate by 25 basis points to 6 per cent. (One basis point is one hundredth of a percentage point.) Rarely does one see market participants so happy after a rate hike. There was virtually no impact on the government bond prices and the benchmark 10-year bond yield rose by just one basis point to 8.22 per cent. Much more than any thing else, RBI Governor Yaga Venugopal Reddy has restored the confidence of the market and credibility of the central bank by biting the rate hike bullet.

In the annual monetary policy in April, Reddy did not hike the rate against widespread expectations of a rate hike. In June, he hiked the rate in an unexpected inter-meeting move and followed it up by raising the amount of a government bond auction to suck out excess liquidity from the financial system. These actions added to the uncertainties and made the bond market nervous. The 10-year bond yield rose from a level of 7.67 per cent before the June rate hike to as much as 8.42 per cent this month, and left the central bank behind the curve. By hiking the rate, the RBI has caught up with the curve and restored the equilibrium in the market.

This is the sixth hike since the rate hardening cycle began in October 2004, the third since the beginning of calendar year 2006 and the fourth in the past eight months. With this hike, the reverse repo rate and the bank rate "" which is RBI's medium-term signal on interest rates "" have converged at 6 per cent. Does this indicate the end of the cycle of rising rates? Possibly not. The RBI has certainly not reached the neutral zone but attained a level from where the rate trajectory can move either way, depending on the external developments (read: what other central banks do) and domestic events (credit growth and inflation rate). With the RBI no more behind the curve, the overwhelming bias in favour of rising rates is not there any more.

However, the bond yields will not remain flat for long. They will rise in tandem with the progress of the government borrowing programme. The government's gross market borrowings at Rs 69,533 crore in financial year 2006-07 (up to July 17) is only 38.2 per cent of the budget estimate. The net market borrowings at Rs 34,572 crore is 30.4 per cent of the estimate. With more bond auctions taking place, the prices are bound to go down, pushing up the yield gradually.

The immediate action will shift to the loan market now. The cost of money for all borrowers "" retail and corporations "" will go up once the liquidity in the system starts tightening. The daily reverse repo window of the RBI has been drawing over Rs 30,000 crore worth of liquidity for quite sometime now but this will dry up once the government aggressively pushes for its market borrowing.

Non-food credit of scheduled commercial banks rose by Rs 37,749 crore, or 2.6 per cent, up to July 7. In the corresponding period last year, the rise in credit was Rs 19,948 crore or 1.8 per cent. This is the highest first quarter expansion of credit in the past five years. On a year-on-year basis, the increase in non-food bank credit has been 32.9 per cent (Rs 3,71,993 crore) on top of an increase of 31 per cent (Rs 2,60,164 crore) last year. Retail lending rose by 74 per cent on a y-o-y basis with growth in housing loans being 115.5 per cent and commercial real estates 101.3 per cent. The year-on-year growth in credit to industry was 26 per cent by May 2006. The only way of reining in the phenomenal growth in credit is making money dearer for the consumers of loan.

This has been happening. The public sector banks have been jacking up their loan prices quietly. Even though there have been four reverse repo rate hikes since October last year, most public sector banks have hiked their prime lending rate only once. This is because officially they do not want to be seen making credit expensive when Finance Minister P Chidambaram is keen on maintaining the flow of credit. Instead of hiking their prime lending rates, they have continuously been raising their sub-prime rates. This will increase with the latest reverse repo rate hike.

The scene is quite different for private banks as they are not under the glare of North Block. ICICI Bank has raised its benchmark advance rate (linked to both corporate and home loans) four times since January. The bank's benchmark rate is now up from 11 per cent on January 2 to 13.25 per cent now. We may soon see another round of hike. Ditto for HDFC, which has hiked its retail prime rate twice since February "" from 10.75 per cent to 11.75 per cent. Rates for all loans across sectors will rise now. However, as long as the cost of loans for corporate India in percentage terms is lower than the country's nominal GDP growth, rising rates are unlikely to derail India's growth story.