INDIA BUSINESS WORLD - JUNE 2006
THE MONTH THAT WAS...

RBI MOVES TO REIN IN INFLATION, HIKES RATES BY 25 BPS

   THE days of easy money are over. Interest rates are set to rise across the board on all loans including home loans with Reserve Bank of India hiking the short-term benchmark interest rates. The rate hike, aimed at reining in inflation, caught most bankers offguard.

However, he said RBI's actions were understandable given the global meltdown in equities and the concerted move by central bankers across the world to push up interest rates to tame inflation.

European Central Bank and the Southern Central Bank also raised rates. However, most feel that RBI's timing was inappropriate given the slide in Sensex and a lacklustre bond market. “Why now? It should have have happened in April,” said a disappointed bond dealer.

RBI said on a review of current macroeconomic and overall monetary conditions, it has decided to hike by 25 basis points the repo and reverse repo rate. The reverse repo -- the rate at which RBI borrows from banks -- is now 5.75% while the repo rate -- the rate at which RBI lends to banks -- has also been raised to 6.75%. More than a signalling effect the rate hike has a direct impact as deposithungry banks will be in a position to offer more to depositors.

This in turn will push up loan rates. Sources in ICICI Bank said that the rate hike would in all likelihood push up interest rates for customers of the bank. The official stance of the bank was that lending rates were linked to cost of funding, which in turn reflected money market conditions. The HDFC chief however indicated that the country's largest home finance company would hike loan rates if funding cost in the medium and long-term rise.

“The Reserve Bank of India's decision to hike the repo and reverse repo rates is a clear indication of the fact that rates have been hardening for some time” said M Balachandran, Chairman, Bank of India.

THE Reserve Bank of India 's rate increase is seen to be targeted at an imminent hike in inflation following the hike in fuel prices. The pre-emptive strike is expected to make it costlier for manufacturers and traders to hold inventories and thereby ease the pressure from the supply side. A fall-out of the rate hike would be a fall in asset prices — an area over which RBI has expressed concern in the past.

The rate of inflation as reflected in the index of wholesale prices has already gone up to 4.74%. Further pressure was in any case expected because of the traditional rise in price of pulses during the monsoon. Until now the government has been trying to micro manage inflation through diktats to cement companies and easing imports. However, inflationary expectations have soared following the hike in fuel prices. This bankers say has prompted RBI to go in for macro measures.

Higher short-term interest rates will also help curb volatility in the money markets. By raising overnight rates RBI has made it difficult for dealers to buy dollars from borrowed rupees thereby easing pressure on the demand side. Before the rate hike by the Reserve Bank, the rupee weakened to 45.97 marginally lower from its previous close of 45.96. Money market dealers expect the maximum impact to be felt in the short-term as the corridor for call money rates has now been moved upward. At the longer end the pass through effect would be far lower around 10 basis points dealers say. However, some dealers do not rule out yields on the 10-year paper touching 7.75% up from last week's high of 7.68%.

Rise in the cost of real estate is likely to get arrested if home loan rates rise further. Already fixed rate home loans cost more than 10%. Lenders say that if equated monthly instalments go up significantly those looking to upgrade or buy additional homes as investment may shelve their decisions. This would in turn lower the demand for housing and thereby bring down prices.

This would in turn impact treasury bill yields, which will hit corporate borrowing through commercial paper. Since banks are now assured 25 basis points on their surplus deposits parked with RBI, the more aggressive ones would pass on the hike to customers in the form of higher deposit rates. This would in turn push up the cost of funds for banks and translate into higher lending rates. Bankers say that home loans are among the first loan products to witness a rise in interest rates since interest rates on home loans are uniform across their portfolio.

With the repo rate hike, one more round of deposit rate hike is almost certain as most banks have named deposit mobilisation as a major challenge during the current fiscal year. Few of the country's public sector banks foresee a major challenge to mobilize sizeable amount of deposits in order to fund the growing demand for credit, especially from the infrastructure sector in the current financial year. Addressing a media at the summit on Financial Inclusion organised by Skoch Consultancy bankers reiterated that in sharp contrast to the past when the challenge was to step up the pace of credit growth, now banks are facing a pressure to gather deposits to meet the demand for rising credit. As such, banks have also witnessed a slowdown in credit offtake in the past two months, which is expected to see a rise post-September. MV Nair, Union Bank of India 's CMD, pointed out that although there is enough liquidity within the system, credit growth will pick up in the third quarter with projects in sectors like power and aviation requiring credit.