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

Government has put his cards on the table. On Tuesday, a hawkish Reserve Bank of India governor Yaga Venugopal Reddy hiked the key shortterm interest rates by a quarter point — second time in 45 days, paving the way for banks to raise interest rates on loans, as well as deposits.

A higher outgo on home loans, more expensive consumer credit and corporate loans will begin to hurt. For instance, leading mortgage players — HDFC and LIC Housing — have said they will raise rates; so has large public sector banks such as PNB and OBC, while the biggest private bank ICICI Bank will soon take a call.

But driven by a surge in demand, risks in global markets and geopolitical uncertainties, Mr Reddy has spelt out his priorities loud and clear: in no way will he allow inflation to cross 5-5.5% in the medium term, he told the media after releasing the quarterly monetary policy statement. Even if it calls for a pre-emptive move like a rate hike.

Mr Reddy, who has often been criticised for spooking the market, sprung a pleasant surprise by his unambiguous stand. His concerns were best captured when he said, “We have basic strengths. With these strengths we can run, but if you try to run faster than what your strength allows you, you will fall. Our point of view is that banks should lend only as much as they can mobilise.....Credit growth cannot be maintained at 30%...it has to decelerate.” The dangers of inflation, the policy hints, lies not just in higher crude price, but also in spiralling in local demand, which is manifested in a robust loan offtake from banks.

 HIGHER rates are thus aimed at discouraging spending, and softening a likely pressure on prices. Mr Reddy is first RBI governor to hint at ‘inflation targeting' in no uncertain terms, which also reflects a greater confidence to rein in inflation. “The inflation target is informal, indicative and self imposed,” said Guv.

The stock market, which had factored in a rate hike, have a thumbs up to Mr Reddy. Sensex rose 200 points (1.96%), while Bankex shot 4%. Bond prices slipped marginally, but market was relieved that the hike is over, and RBI will not raise rates at least for the next 3 months.

Interestingly, Mr Reddy kept Bank Rate — a medium term rate signal — unchanged at 6%. But short-term rates that have been hiked: repo — the rate at which lends or infuses fund in the system — from 6.75% to 7%; and reverse repo — the rate at which RBI borrows or mops fund — from 5.75% to 6%. Hiking Bank Rate would have called for revising the inflationary target beyond the 5-5.5% band.
   Besides the runaway loan growth, the quarterly policy statement has flagged off issues which possibly worries the monetary authority. RBI has pointed out that bank investment in government and other approved securities has gone down, which shows that banks are not participating in the government borrowing programme, thereby leaving it to insurance companies and pension funds which do not have a great appetite for gilts. RBI has also underscored that as proportion to budgetary estimate, the gross fiscal deficit and revenue deficit increased to 48.5% and 81% respectively, during April-May compared to 31.5% and 46.3% in corresponding period last year.