Banks may defer walking in RBI's footsteps

Mint Road hints at a pause in the tightening cycle, with the monetary situation drawing close to normal.

The Reserve Bank of India raised key rates on Thursday, but at the same time signalled that its monetary tightening cycle that started nearly a year ago may take a pause.

RBI raised the reverse repo rate by an aggressive 50 basis points to 5 per cent and repo rate -- the rate at which it lends to banks -- by 25 bps to 6 per cent with immediate effect. It is a move that is likely to prompt banks to review their cost of borrowing.

This is the fifth time this year that the central bank has raised rates to rein in high inflation.

Bankers said while deposit rates will go up soon, any increase in lending rates would take some time, with healthy growth in industrial production and services and good monsoon rains promising a robust rabi harvest.

"Inflation rates have reached a plateau, but are likely to remain at unacceptably high levels for some months," RBI said in its mid-quarter monetary policy review.

"The policy actions taken over the past three quarters have been partly motivated by the need to end the prevalence of negative real interest rates."

"The Reserve Bank believes that the tightening that has been carried out over this period has taken the monetary situation close to normal," RBI said.

"Consequently, the role of normalisation as a motivation for further actions is likely to be less important."

Inflation slowed to 8.5 per cent in August, compared with 9.8 per cent a month earlier.

RBI said notwithstanding the slight moderation, headline inflation remains significantly above the trend of 5-5.5 per cent in the 2000s. It has set a 6 per cent target for inflation by March 2011.

August's drop in the inflation rate was mainly due to a fall in the prices of primary articles and 1-percentage point difference between the old series and new base of 2004-05. Inferences from both the series of inflation are similar, RBI said.

"We are seeing an upward bias in interest rates," said M D Mallya, chairman, Bank of Baroda. "We have to see the pick-up in credit off-take for any increase in interest rates, as the festival season begins. We constantly keep monitoring interest rates."

RBI's rate hikes have not gone down well with Indian companies, who expressed fear that the move would push up borrowing costs, making some of their projects unviable and hurting expansion plans.

Industry chamber CII said, "With banks already raising their lending rates, we are concerned that industry may find it difficult to fund capacity expansions, and even some existing projects may become unviable."

"If banks are unable to absorb the cost and pass it on to customers, it will have an impact, especially on weaker borrowers like small and medium enterprises," Federation of Indian Chambers of Commerce and Industry secretary-general Amit Mitra said.

On the other hand, Mitra said increasing the reverse repo rate by 50 basis points is tantamount to asking banks to give more money to RBI, rather than lend to potential investors.

"This, in turn, will definitely deter investment at the margin," he added.

RBI also sounded a note of caution on the returns on bank deposits. "If bank credit is not to become a constraint to growth, real rates need to move in the direction of encouraging bank deposits," the central bank said in its statement.

Growth of bank deposits this year has been much slower than credit off-take.

After RBI's previous monetary policy review on July 27, as many as 40 banks raised their deposit rates and 26 increased lending rates, RBI said. Bank deposits grew 14.4 per cent year-on-year until August 27, lagging credit growth of 19.4 per cent in the same period.

"There is an upward bias to rates, but whether they rise further will depend on inflation," said R V S Sridhar, president and head of global markets at Axis Bank in Mumbai.

"A hike in lending rates may come with time, but there will be no hike in lending rates unless deposit rates rise significantly. Going ahead, inflation could also decline."

Senior officials at other state-run banks echoed the view that there would be pressure on the cost of funds, though a decision on raising lending rates could be taken in October, when the festival and traditional busy season sets in and increases demand for loans.

RBI also reduced the difference between repo and reverse repo rates to narrow the "volatility in overnight call money rates" and improve the transmission of its monetary policy mechanism, the central bank said.

"I think it is in the right direction, because now the corridor has been narrowed and there is still inflationary pressure in the system," Finance Minister Pranab Mukherjee said in New Delhi. "I think the adjustment of repo and reverse repo will help to mop up additional liquidity, which is putting pressure on the system."

Market reaction to increased rates by RBI was muted. Yields on 10-year government bonds rose 1 basis point to 7.96 per cent.

The weighted average of overnight call money rates rose 5.89 per cent, compared with 5.78 per cent yesterday, after rising by as much as 6.10 per cent.

Higher-than-expected realisation from telecom auctions have "virtually eliminated the risk of fiscal deficit overshooting the targeted 5.5 per cent", RBI said.

This will help stabilise market expectations of liquidity and interest rate movements, the central bank said.

With the prospects of inflation declining in coming months, economists and analysts also see RBI slowing future increases in its rate.

"With monetary conditions tightening and global demand still sluggish, we retain our view that growth and inflation are likely to moderate in the coming quarters and that RBI is close to pausing its rate-hiking cycle," said Sonal Varma, an economist at Nomura Financial Advisory and Securities (India).

"In many ways, there is a change in tone to a more positive one, as RBI has said that tightening done so far has taken the monetary situation close to normal," said Rohini Malkani, an economist with Citigroup, in her report.

"However, given that inflation remains significantly above trends, we expect one or possibly two more hikes in the next 6 months. This should take repo and reverse repo rates to 6.50 per cent and 5.50 per cent, respectively."