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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » New Reserve Bank of India Governor shocks markets with rate hike on inflation fears

New Reserve Bank of India Governor shocks markets with rate hike on inflation fears

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K.Haputantri

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New Reserve Bank of India Governor shocks markets with rate hike on inflation fears
September 20, 2013, 8:50 pm
By S. Venkat Narayan, Our Special Correspondent
The Island

NEW DELHI, September 20: The Reserve Bank of India (RBI) surprised the markets on Friday by raising its key interest rate, signalling its new Governor Raghuram Rajan’s concern over inflationary pressures in the economy. It also began to loosen measures to tighten liquidity it put in place in July to stem the rupee’s decline.

The 0.25 percentage point repo rate hike took the markets by surprise. Stocks and bonds fell and so did the rupee after the RBI’s policy announcement at 11am.

In the first monetary policy under Rajan, who took charge as governor on 4 September, RBI raised the repo rate, at which it lends overnight funds to commercial banks, to 7.5% from 7.25%.

"The need to anchor inflation and inflation expectations has to be set against the fragile state of the industrial sector and urban demand. Keeping all this in view, bringing down inflation to more tolerable levels warrants raising the LAF repo rate by 25 basis points immediately," RBI said in the policy. One basis point is one-hundredth of a percentage point. LAF is short for liquidity adjustment facility.

At the same time, RBI reduced the rate on borrowing from the so-called marginal standing facility (MSF), an RBI lending window for commercial banks, by 75 basis points to 9.5%, as it starts to unwind the liquidity tightening measures put in place two months ago. The rate had been hiked by 2 percentage points in July in a bid to protect the rupee, .

RBI also said banks will be required now to keep 95% of the cash reserve ratio (CRR), the portion of deposits they need to keep with the central bank, at any given point in time, reducing the limit from 99%. The CRR was left unchanged at 4%.

The measures to loosen liquidity came two days after the US Federal Reserve decided not to ‘taper’ its $85-billion-a-month bond buying programme, which reinforced confidence that foreign fund inflows would return to emerging markets for better returns, helping the rupee stabilize.

"The repo rate hike in this meeting was surprising," said A Prasanna, chief economist at ICICI Securities Primary Dealership Ltd. "It’s a two-track policy. On one hand, RBI is unwinding the liquidity-tightening measures and on the other hand hiking repo rate. The broader message is that RBI is serious about inflation control," Prasanna said.

The Bombay Stock Exchange’s (BSE) benchmark equity index, Sensex, fell by 1.67%, or 350 points, to 20,301.49 points shortly after the announcement from 20,641.26 points earlier. The yield on the 10-year benchmark bond shot up to 8.39% from 8.206% before policy; bond prices and yields move in opposite direction.

The BSE Bankex fell by 2.88% to 12,331.62 points shortly after the announcement from 12,740.50 points earlier.

Since April 2012, RBI has cut its policy rate four times to boost the economy that grew 5% in the year ended 31 March, the lowest in a decade. Economic growth slumped to 4.4% in the June quarter.

But persistently high food inflation and a rise in the wholesale price-based inflation in recent months have limited the room for the apex bank to effect any further easing in its monetary policy stance, economists said

Rajan, who took over from Duvvuri Subbarao on 4 September as RBI governor, has underlined his concerns over inflation. After easing to 4.86% in June, wholesale inflation accelerated to 5.79% in July and 6.1% in August. Retail inflation, too, has remained high—hovering near the double digits. It was 9.64% in July and 9.52% in August.

"Rajan has continued Subbarao’s anti-inflation stance. He has continued the battle to fight inflation. It is evident that uncertainty on exchange rate and inflation persists," Madan Sabnavis, chief economist, at Care Rating said. "While unwinding the measures, RBI should have given its rationale as far as the impact of liquidity tightening measures on rupee."

The Indian rupee began its recent free fall on 22 May, when US Federal Reserve chairman Ben Bernanke hinted an early exit from the Fed’s monthly bond buyback programme. This, coupled with domestic economic woes, put pressure on the rupee. The unit has dropped about 10% since 22 May.

The rupee touched its all-time low of 68.85 against the dollar on 28 August. Since then it has recovered 11.44%.

However, with the Fed deciding to hold off tapering economic stimulus for the time being, experts expect the money markets to stabilize for now. This, accompanied by an expected decline in inflation, will enable RBI to cut rates in the coming months, economists said.

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