Tamal Bandyopadhyay: Reddy, get set, wait?

If Reserve Bank of India Governor Y V Reddy goes for a hike in the reverse repo rate next week when the central bank is set to review its monetary policy, it will be the sixth rate hike in the Reddy regime. Between June 8, when Reddy last hiked the reverse repo rate, and July 25, when the quarterly review is due, the gap is only six weeks. So far, the minimum gap maintained between two rate hikes by Reddy has been three months. After hiking the reverse repo rate to 5.25 per cent in October 2005, Reddy hiked it again in January this year to 5.5 per cent at the quarterly review of the policy.

In this century, the reverse repo rate "" the rate at which the RBI sucks out liquidity from the system "" was at its peak in April 2001 at 6.75 per cent. By the time Reddy took over as governor in late 2003, the reverse repo rate came down to as low at 4.5 per cent. Between October 2004 and now, Reddy has raised it to 5.75 per cent through five hikes of 25 basis points each. (One basis point is one hundredth of a percentage point.)

Despite this, the interest rate differential between India and the US has been steadily shrinking. For instance, in May 2004, when the reverse repo rate was ruling at 4.5 per cent, the US Fed funds rate was 1 per cent, making the interest rate differential 3.5 per cent. Since then, there have been 18 hikes in the US rate, 25 basis points each, raising it to 5.25 per cent. This has reduced the interest rate differential to a mere 50 basis points. The RBI has shown much less aggression vis-à-vis the US Fed while paring as well as raising interest rates.

However, the impact of the rate hike has not always been uniform. For instance, after the reverse repo rate was brought down to 4.5 per cent in August 2003, the yield on the 10-year government bond "" a barometer for market rates "" dipped to as low as 4.97 per cent in mid-October 2003. With the rise in reverse repo rate to 4.75 per cent in October 2004, the yield on the 10-year paper went up to 6.85 per cent. Subsequently, it rose to around 7.35 per cent in April 2005, when the reverse repo rate was hiked again but came down to 7.10 per cent in October last year, when the reverse rate rose to 5.25 per cent. In January this year, another 25 basis points hike in the reverse repo rate translated into a marginal hike in the 10 year bond yield "" about 7.18 per cent. Since then, it went up to as much as 8.38 per cent. It is now ruling at around 8.36 per cent. In fact, the 10-year bond yield has risen by one percentage point rise since the beginning of this financial year as it was ruling at 7.46 per cent in March. This is even though the hike in the reverse repo rate has been a mere 25 basis points. So, the RBI is distinctly behind the yield curve.

Since the last rate hike on June 8, quite a few things have happened. The US Fed has hiked its base rate by another 25 basis points to 5.25 per cent and Bank of Japan has ended its six-year regime of zero interest rate even as Bank of England has not made any change in its policy rate.

The RBI, on its part, has conducted the government borrowing programme in such way that has sent conflicting signals to the market. On June 22, it raised quantum of the scheduled government paper auction by Rs 4,000 crore to Rs 9,000 crore, apparently to suck out excess liquidity from the system. That made the market nervous and helped the 10-year bond yield pierce the 8 per cent level. At the next bond auction, on July 11, the RBI reversed the trend and cut the size of the auction by Rs 3,000 crore to Rs 7,000 crore to soothe the frayed nerves of the market. A large portion of the auction devolved on the primary dealers who subscribe to the papers as the RBI was not willing to fix the cut-off yield at a higher level.

Going forward, what will be the RBI stance on July 15? There is a case for a rate hike as the latest industrial production data shows that industrial activities in the new financial year are stronger than expectations and the overall demand for bank credit has not dampened even though there is a slowdown in consumer loans and home loans. With the global oil price hitting new highs amid rising geo-political tensions in West Asia, managing the 5 to 5.5 per cent inflation target will be daunting for the central bank. Besides, the RBI also needs to ring fence the rupee against any possible attack by the speculators.

If the reverse repo rate is indeed hiked by another 25 basis points to 6 per cent, the RBI would need to do something with the bank rate that is currently pegged at 6 per cent. The bank rate is a medium-term signal rate by the central bank while reverse repo rate indicates RBI's short-term goal. The two rates possibly cannot be converged. So, the RBI would either have to hike the bank rate too or bury it quietly.

However, it's a bit early to speculate on the fate of the bank rate as Reddy may even choose to wait a while before hiking the reverse repo rate. He may not like to go for rapid action on the rate front and derail the growth momentum at this juncture. After all, he does not necessarily need to wait till the October mid-year review of the policy to effect a rate hike. It can be done any day. He had proved that in June.