Get ready for higher interest rates as RBI hikes repo, reverse repo rates  

July 27, 2010

 The central bank's move to hike repo and reverse repo rates by 25 bps and 50 bps respectively and reducing the width of LAF corridor to 125 bps, will put pressure on banks to increase deposit rates as well as hike auto, home and commercial loans

The Reserve Bank of India (RBI) on Tuesday raised its short-term lending (repo) and borrowing (reverse repo) rates by 0.25% and 0.50% respectively to bring down inflation to 6% by March 2011 from double digits now, but the move will put pressure on banks' interest rates. In its monetary review, the central bank, however, kept its cash reserve ratio (CRR), the cash which banks are required to keep with the RBI, unchanged. The move will put pressure on banks to increase deposit rates as well as auto, home and commercial loans.

After releasing the first quarterly monetary policy, RBI governor, D Subbarao told reporters, "We expect credit to be dearer... As credit demand picks up, we expect lending and deposit rates to go up."

Echoing the same view, State Bank of India (SBI) chairman OP Bhatt said that the pressure on interest rates, which has been there, will go up further, following the RBI move. "Upward bias has definitely built up and now all depends on credit off-take... every bank will absorb it for now and put it into their calculations. Different banks have different profiles, and at SBI, we will be looking and thinking (at raising rates) over today and tomorrow," Mr Bhatt said. The increase in short-term repo rate to 5.75% and reverse repo rate to 4.5% will be effective immediately.

The RBI said that banks increased their term deposit rates by 75-100 basis points (bps) between March 2010 and 16th July. On the lending side, benchmark prime lending rates of scheduled commercial banks remained unchanged during July 2009 and June 2010.

Ambit Capital Pvt Ltd in a note said, "We are at the beginning of the increasing interest rate cycle and with credit growth at about 22%, banks are gradually gaining pricing power. We expect deposit rates to start inching upwards earlier than lending rates, thus squeezing net interest margins (NIMs) during the current quarter."

The RBI maintained that while liquidity pressures will ease, the system is likely to stay in deficit mode for a while. In an attempt to strike a balance between the uni-directional surplus mode, as prevailing until mid-May 2010 and a bi-directional mode, the central bank also reduced the width of the liquidity adjustment facility (LAF) corridor to 125 bps from 150 bps.

"This (reduction of LAF width) will reduce the volatility in short-term rates as we do expect to see swings in net liquidity from outflows to inflows and vice-versa in the next couple of months," said DR Dogra, managing director and chief executive of CARE Ratings.

By reducing the LAF corridor by 25 bps, the RBI is subtly incentivising banks to raise deposits at a faster pace, thereby, staying in surplus mode so as to take advantage of the higher reverse repo rate. As a result, deposit rates are likely to inch upwards while base rate movement will lag deposit rate increases.

The RBI raised upwards the inflation target from 5.5% to 6% and said that the economy will grow by 8.5%, up from the earlier projection of 8% this fiscal. The overall inflation has been in double digits for the past five months and stood at 10.55% in June.

Although finance minister Pranab Mukherjee has said that the steps announced by the RBI will check inflation without hurting growth, bankers and the industry fear that the initiatives will put pressure on interest rates.

"While taking cognisance of some moderation in inflation in recent months and the potential positive impact of a normal monsoon, the RBI has taken steps to address the increasing generalisation of inflation across food and non-food items.

The monetary measures announced are a continuation of the normalisation of policy rates that RBI has been bringing about over the past few months, and are broadly in line with market expectations," said Chanda Kochhar, managing director and chief executive, ICICI Bank Ltd.

According to a PTI report, Central Bank of India executive director Arun Kaul said, "The monetary action by RBI is aimed at attacking inflation. It has made funds costlier for banks. It is a signal for upward movement of interest rates."

Earlier this month, the RBI had hiked repo and reverse repo rates by 0.25% as inflation remained above 10% for the fifth month in succession. Prior to this, the central bank had raised its key rates thrice since January.

"Inflationary pressures have exacerbated and become generalised with demand-side pressures clearly visible, given the spread and persistence of inflation, demand-side inflationary pressures need to be contained," the RBI said.

Ramanathan K, chief investment officer, ING Investment Management India, said, "The increase in reverse repo rate by 50 bps was above market expectation. Clearly the policy focus has shifted to addressing demand-side pressures and containing inflation. Given the recent frequent inter-policy rate actions and the need for a faster calibrated exit, the RBI has also instituted a mid-quarter review of monetary policy which would reduce the negative surprise element of such inter-meeting policy actions."

While the stock markets took the rate hikes in their own stride, industry chambers, however, said that the RBI's move to up short-term rates may hinder industrial growth as interest rates are likely to be jacked up.

According a PTI report, Federation of Indian Chambers of Commerce and Industry (FICCI) president Rajan Bharti Mittal said, "This is a huge surprise as general expectation was at most 25 bps increase in both rates... The reverse repo increase will incentivise parking of funds by banks with the RBI, thus reducing lending opportunities to industry." Mr Mittal's comment is strange because the stock market and some interest-sensitive segments of the economy such as real estate have not been surprised by the hike.

In addition to the monetary interventions being made by the RBI to contain inflation, the Confederation of Indian Industry (CII)'s director general Chandrajit Banerjee said the chamber is keen that the supply-side issues are addressed effectively to ensure that going forward, growth is not affected by supply constraints.

Banks, especially private banks, have a different view. Neeraj Swaroop, regional chief executive, India and South Asia, Standard Chartered Bank, said, "Given the central bank's reputation for backing intent with sound action, the policy reassures domestic and international investors for whom India is a top destination."

"Another positive message from the policy is the RBI's confidence in the strength of the domestic recovery. Set against an uncertain global environment, the broad-based recovery in India reflects the fundamental balance sheet strength of the country's investors and consumers, auguring well for sustained long-term growth," Mr Swaroop said.

Ms Kochhar of ICICI Bank said that the RBI's move to leave the CRR unchanged would ensure that the system has adequate liquidity and is in consonance with measures adopted by the RBI in the recent past to enhance systemic liquidity in anticipation of advance tax payouts and telecom auction-related outflows. This approach, along with the narrowing of the LAF corridor in this policy review, would serve to maintain stability in financial markets even as monetary policy in general is tightened to normalise policy rates and contain inflation, she added.

However, a few market participants seem to be in a wait-and-watch mode. "The repo rate hike was on expected lines. We don't see any immediate hike in interest rates. But one more round of hikes could see lenders increase their interest rates," Renu Sud Karnad, managing director, HDFC Ltd, told Moneylife. On the demand for housing loans, she said, "The demand for housing depends on the overall cost of buying a house and till such time buying a house is affordable, there will be demand from buyers." — Moneylife Digital Team