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What if RBI Governor hikes interest rates tomorrow?

By Abheek Barua
Last updated on: October 26, 2009 12:18 IST
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D SubbaraoEven if he does, it's unlikely to have a palpable impact on credit markets, says Abheek Barua.

If Reserve Bank of India governor D Subbarao follows the global trend in taking his rate decision in tomorrow's monetary policy, then he is unlikely to hike.

While there are certainly more hawks perched on monetary policy committees of central banks around the world now than a couple of months ago, the doves still have the upper hand.

The dominant view is that unless there is more confirmation that economies are on a one-way street to recovery (that the recent improvement in macro data is not just fuelled by some frantic but temporary inventory re-stocking), central banks should stay on hold.

There have been a couple of notable exceptions. The Bank of Israel, now headed by the formidable Stanley Fischer, hiked its policy rate by a quarter of a percentage point as early as August in response to rising inflation.

More recently, the Reserve Bank of Australia surprised markets by raising its policy rate in the first week of October. One could argue that the RBA's move marked the beginning of a process of decoupling between the monetary policy in emerging economies and that in the developed world.

The Australian economy is a close play on China and other emerging Asian economies. Thus the RBA's decision was as much a response to its assessment of Asia's growth and inflation prospects as it was to Australia's own macro environment.

It is quite likely that Asian central banks will follow in the next few months and by early 2010, we could see higher rates across the board in Asia. India is unlikely to be an exception and as headline inflation spikes on the back of a weak base, we could see RBI hiking rates for the first time in December or January.

But RBI governors have been known to surprise the markets. Given the continued traction in food and other agricultural product prices and an adverse base effect that kicks in from this month, a central bank that wants to 'stay ahead of the curve' would want to take a cue from RBA and hike rates in tomorrow's policy itself. What happens then?

I would argue that while there could indeed be some impact on sentiment, there is little reason for borrowers to feel gutted if RBI raises rates tomorrow or pushes up the cash reserve ratio.

Banks do not change their deposit and lending rates in response to monetary policy rates alone. The balance of the demand for and the supply of funds matters just as much and from that perspective, there is little room for change.

For one, credit growth remains exceptionally weak (credit growth between March and early October 2009 was a paltry 4.1 per cent compared to 10.5 per cent in 2008). It makes sense for banks to try hard to push the demand for loans up, not curtail it further by raising loan rates.

If their assets are not growing, it does not make sense for banks to chase liabilities by raising deposit rates. In short, a small policy rate increase at this stage will essentially remain a gesture that might have an impact on inflation expectations but is unlikely to affect credit markets.

Government bond yields are, however, likely to move up both at the short end and the long end if rates are hiked. This could impact government borrowing costs a tad (particularly state governments that are likely to be aggressive in the second half of this fiscal).

However, the disconnect between the trajectory of bond yields and credit rates that has set in for the past few months is likely to continue.

Second, a hike in policy rates at this stage does not necessarily mark the beginning of an aggressive hiking cycle. Given the twin demands of managing the government borrowing programme and supporting an economic recovery, RBI is likely to exit from its 'super-accommodative' monetary policy stance in a slow, calibrated fashion.

While primary product inflation is undoubtedly high, factors that typically abet 'core' inflation remain benign.

Capacity utilisation, for instance, that correlates well with inflation build-up remains weak.

The RBI's Industrial Outlook Survey that provides a quarterly assessment finds that while the slide in capacity utilisation that started in mid-2008 was arrested in the April-June 2009 quarter (the last quarter surveyed), the level was way lower than pre-crisis levels.

I suspect that things haven't improved dramatically since then and capacity constraints are unlikely to bind until the end of 2010. RBI needs to stay vigilant and signal to the market that in its bid to support growth, it isn't willing to ignore inflation altogether -- this warrants mild changes in policy rates through 2010, not monetary tightening in full throttle.

The impact on the rupee is trickier to gauge. Higher local rates should, in theory, lead to appreciation pressure as the interest rate differential works to the rupee's advantage. But this has to be set off against the impact on equity markets that are likely to sell off if a rate increase comes through.

Whatever the near-term impact of the rate is, my sense is that the appreciation in the rupee will continue over the next few months. This would reflect a sharp drop in premiums on risky assets (including emerging market debt and equity) mirrored in extreme bearishness on the safe-haven currency, the US dollar.

Unless the dollar reverses its path as risk aversion returns, the rupee will remain bid. Local rate decisions will make only a marginal difference to this, if at all.

RBI's decision tomorrow is important for analysts who are trying to gauge when and how the central bank will shift from its super-accommodative stance. For borrowers and lenders, and those who transact currencies, it is unlikely to have a palpable impact.

The author is chief economist, HDFC Bank. The views expressed are personal

Image: D Subbarao

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