RBI hikes repo rate by 50 bps, CRR by 25 bps

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The Reserve Bank of India or the RBI  hiked repo rates by 50 bps and cash reserve ratio or CRR by 25 bps on July 29.

The CRR hike will be effective from August 30. On the hike, 10-year bond yield shot up to 9.51%.

The repo rate is at 9% for the first time since October, 2000, while CRR is at 9% for the first time since November, 1999.

The RBI said inflation has emerged as the biggest risk to global outlook and bringing down inflation is the highest priority. RBI is aiming to bring down inflation to 5% asson as possible. RBI claims it's a realistic endeavour to lower inflation to 7% by March '09.

The RBI has more than anticipated moderation in industrial and services sector.

Reacting to this unexpected move by the RBI, Ajay Shah , Senior Fellow of NIPFP, said the rate hike measures are on right track.

Shah doesn't think the rate hike will have a big impact on all sectors. Although, he also has a view that a credit policy that does not address currency cannot be called credible.

Abheek Baruah , Chief Economist at HDFC Bank , said growth rates will need to be revised lower. He expects growth to come down to 7.3-7.6%.

S Narayansami , CMD of Bank of India on the other hand is shocked as he said the RBI action was beyond expectation because inflation was anyway looking to getting moderated.

"The action taken by RBI is slightly beyond my expectations. I had clearly foreseen a 25% hike in CRR as well as in repo. Inflation growth per se getting moderate is a matter of comfort. It is clearly evident that the monetary measures initiated by RBI are yielding the desired results," he said. 

He said banks will definitely look at revising interest rates now.

Narayansami is of the view that the Government is looking to tame inflation rather than moderate it.

He agrees that he may have to hike lending rates by a full 50 bps. "It is should be minimum. It is evident that money has been made very dear and expensive therefore the whole idea is to contain aggregate demands. If it is going to affect our bottomline, we will have to go for a minimum of a half percentage revision in PLR (prime-lending rate) for the time being. But having said that, it will augur well for the Indian economy if it's going to tame inflation at least in the near-term because India will still continue with best economic fundamentals, will be one of the best climates to invest in the medium-term."   

In the short term, this move is expected to be harsh on banking and the real estate sector, believes Nilesh Shah , Deputy MD of ICICI Prudential . He sees FY09 earnings growth expectations coming down to 12-15%.

Even global investors have tamed down their India growth expectations post the rate hike. Robert Prior-Wandesforde , Senior Asian Economist of HSBC Holdings sees FY09 GDP growth at 7.5%, while FY10 is seen at 7.8%.

What the industry would have liked to see in the policy

Ajay Shah elaborates, "I still think that it is on the right track, but there are still some concerns that we have to worry about. The story of the exchange rate is not yet clear, interest rate is one tool to influence inflation, but exchange rates are even stronger tool to influence inflation.

I would have liked to see some changes on the capital control, I would have liked to see a reversal of the capital control of 2007, I would have liked to see a programme for sale of reserves. We are still not understanding the role of exchange rates in this inflation and I am not seeing that being used adequately.

The other concern I have is of the distance between the repo and the reverse repo; money market conditions could change dramatically and the call could be closer to the bottom of the corridor and we still have a very big gap between the two rates, I would have been happier if the gap between the two rates was more like a 100 bps." 

How will it impact growth?

Baruah said, "I think what is implicit in this monetary policy signal is that the RBI wants lending rates in the system to harden quite a bit more. I think on average, the median increase in lending rate has been about 50 bps over the last couple of months. I think the RBI will make sure that it goes up by another 50-75 bps.

Some banks have sort of pre-empted it by going in for larger hikes but the median rate hike is about 50 bps. With another additional of 50 bps hike in effective lending rates that I foresee perhaps growth will come off from the 7.8%-7.9% median forecast that we have from economists. So I think the range could be now between 7.3% and 7.6%. So certainly some downward revision is warranted."

Ajay Shah does not look at this move very positively, "I feel that in India the monetary policy transmission is very weak, so fairly large changes in the interest rate-end don't do all that much to the economy, large parts of the economy just don't care about what happens to the policy rates."

"So while I am the first to say that in combating inflation we need strong real rates at the short end and we are not there yet," he adds. 

While Robert Prior-Wandesforde thinks he is quite happy with this year's growth forecast of 7.5% for FY09-10. "We should bear in mind that this kind of rate action will take 12-24 months for the economy to feel the pain of this inflow, so it is going to have bigger impact on the following year's fiscal year growth then in the current year."

Additionally, he has been focusing a lot on the WPI; the ability of the RBI to influence the WPI being very limited, it is the price index that is heavily influenced by international commodity price developments. "I think to be fair, the RBI is probably is taking a slightly broader perspective thinking about consumer price inflation, monetary growth, credit growth, aggregate demand, current account positions, fiscal positions. I think they are taking this broad picture. The message that they are taking is that the economy is continuing to grow rapidly and needs to slowdown and until we get that slowdown, we can't be confident on those bottlenecks and those underlying inflation and signs of excess will be diminished," he said. 

Can there be another rate hike?

RBI has taken a hard stance with this rate hike this time. Expectations were that the plateauing of inflation last week or even crude cooling down would have led them to pause for the moment. But instead their approach seems to be far more hawkish.

Baruah insists it's just a question of timing. "Despite the temporary reprieve on oil prices, the RBI is very concerned about inflation. So whether they did the repo rate hike now or in August, inflation spiking up again is the only issue. My sense was that over the rest of the year, they would have to do between a 50 to 100 basis points increase in the repo rate."

"So I think there maybe more rate hikes, but I don't believe the repo rate is likely to go up by a 200 or 250 basis points which some economists and bond houses have been forecasting. So I am forecasting another 50 to 75 maximum additional repo rate increase," he adds.

Robert Prior-Wandesforde said, "I am looking for another 50 bps repo rate hike from here and 70 bps on the CRR rate before the end of this calendar year. I think there is a bit more to come and these kinds of moves will be triggered by further move up in inflationary pressure in WPI inflation and also the fact that I expect both monetary growth and credit growth to remain above target over that kind of period."

Will it tame inflation?

RBI may be very strongly telling banks that they don't want expansionary credit. Narayansami said, "With the inevitable reversionary interest rates, credit growth will naturally get moderated and we will also fall in-line with the RBI policy to be more cautious in credit expansion because otherwise if we do not contain aggregate demand, the whole exercise will become futile. With inflation management being the focus area, when the RBI is seeing the market responding to the measures taken by them, definitely, the intensity has increased."

He gives a thumbs up to the move, "That means the government wants the inflation to get tamed rather than inflation growth getting moderated. There is a distinct difference between the two. We are going to the taming zone, which is very necessary. It will auger very well for the Indian economy in the medium-term."

How will it impact markets?

Ajay Shah has already wound down EPS expectation from about 20-22% to about 12-15% keeping in mind the current valuation of the market. No one wants to look at the micro numbers, people want to take a macro call. 

"We are in a scenario where people are taking macro calls and moving out rather than looking at micro numbers. The expectation of the market for EPS growth is probably between 10-12% depending upon the current valuation," he said.

In the short-term this policy measure will create pain on the banking and financial services sector stocks and on the interest rate sensitive sectors like real estate. However, over a longer term, it gives the creditability of the Central Bank to fight interest rate expectations and it will probably help recede some of the macro-economic worries people have.

He said, "We have a Central Bank which is alive and functioning and trying to control inflationary expectation within its mandate, so medium-term it will definitely enhance the creditability of Indian economic environment."

What kind of a note has the policy struck with market experts? Nirmal Jain , MD of India Infoline , said, "Market wasn't prepared for this; this is an aggressive stance on tightening the monetary policy whereas most economists and experts believed that inflation is because of pass through of crude oil prices, global inflation and supply side constrains. So most people thought that that doesn't warrant this kind of tightening, which will hurt growth for sure. So market, particularly banking stocks and financials, have come under heavy fire from bears which were expected. But I think maybe market will now seek level between 13,000-14,500 and we do not see any upside or any major trigger which can take the market up in this environment."