labels: rbi, economy - general
RBI credit policy: Refocusing on inflationnews
Rex Mathew
26 October 2005

The RBI has raised both the repo and the reverse repo rates by 25 basis points and most analysts expect further hikes over the next year. Does this mean that the era of benign interest rates are over?

Central banks all over the world are generally fixated on controlling inflation, even at the cost of economic growth. The US Fed is famous (or notorious, depending which side you are on), for its obsession with inflation control and has often been accused of pushing the economy to phases of lower growth through its hawkish interest rate policies. The RBI, as befitting the central bank of a developing country starved of economic growth, has traditionally given more importance to growth.

The latest credit policy review came after some optimistic statements from the finance ministry on inflation and the need to keep interest rates low for sustaining the growth momentum. The finance minister was less convinced about the need for a rate hike as he stated publicly that inflation was within manageable limits. The finance ministry was of the opinion that the effect of high oil prices had more or less been absorbed.

Going by the language of the mid-term review announced yesterday, the RBI clearly differs with the government on both inflation and the impact of oil price. The central bank believes that higher oil prices, considered a temporary phenomenon in early reports, have become a more permanent component in inflation management. The RBI is also of opinion that the pass-through effect of higher oil prices are not fully reflected in the prices of intermediate and final goods. Hence, the central bank seems to have decided to focus more on inflation rather than growth.

The RBI clearly admits that it would be difficult to keep year end inflation at the targeted 5 to 5.5 per cent without necessary policy responses. Hence, it has decided to act ahead of the problem. As a deputy governor of the bank put it, inflation is like toothpaste – once you let it ooze out, it is very difficult to push back. Though the next policy review is due only in January 2006, the RBI has stated that it is ready to take further measures as the risk unfolds.

Given this more aggressive stand on inflation, most analysts were expecting a rate hike of 25 basis points. Some were even predicting a 50 basis point increase. Commercial banks had also braced themselves for the increase and bank stocks had begun to decline ahead of the policy announcement.

As expected, the RBI raised the reverse repo rate, the rate at which it borrows money from the system, by 25 basis points taking it to 5.25 per cent. The repo rate, the rate at which the RBI lends money to the system, has also been raised by a matching margin to 6.25 per cent. The second move was not as widely expected as the first and is being seen as a sign of this new found aggressiveness.

To prevent the market from reading too much into the hikes in repo and reverse repo rates, the RBI has left both the bank rate and cash reserve ratio (CRR) unchanged. The bank rate, currently at 6 per cent, is a token or signaling rate which does not have any operational significance. However, it has some psychological significance as it is used as a reference rate indicating the medium term interest outlook of the central bank. By keeping the bank rate stable, the RBI is allowing itself the flexibility to roll back if economic growth is affected in future. A decent balancing act.

Are cheap loans a thing of the past?
So, is this the end of the low interest rate phase which the corporate sector and retail consumers had become used to?

In the short term, there would definitely be some pressure on interest rates. Most commercial banks have already stated that they are reviewing the interest rates though none has announced a rate hike so far. An across the board hardening of rates is very unlikely in any case.

For corporate borrowers, the era of sub-PLR borrowings may be coming to an end. PLR or prime lending rate is the benchmark lending rate of a commercial bank. Banks have been lending to blue chip companies at rates which are lower than the PLR.

However, this is unlikely to have any significant impact on the investment plans of large companies as multiple avenues of fund raising are open to these companies. Indian companies are increasingly relying on external financing, like external commercial borrowings and foreign currency bonds. In September alone, Indian companies had raised over $1 billion through this route.

For retail consumers, there could be a marginal upward revision on interest rates on home loans and consumer durable loans. This was happening anyway as the demand for retail loans is quite strong. Banks were struggling to meet the credit demand as the deposit side of their business was languishing. Consumers can take a marginal hike in their stride as long as income growth remains robust.

What could upset the RBI's outlook?
The RBI is quite bullish on economic growth and has increased the GDP forecast to 7-7.5 per cent from the earlier 7 per cent. It sees no significant threat to the growth momentum and believes that the marginal increase in interest rates would not affect growth.

The most significant threat to growth, as of now, is high oil prices. Though prices have come down significantly from the recent record levels, the current levels are still not comfortable. The opinion is still divided as to whether the economy has learnt to live with high oil prices. Even the RBI and finance ministry has differing opinion on this.

Though it looks like crude oil prices are trending lower and industry expects it to settle between $40 and $50 per barrel over the next few years, an unexpected rise cannot be ruled out. Oil prices have become highly sensitive to news flows as financial investments in commodity futures have increased significantly. Any significant development affecting oil supplies could take the prices back to record highs.

A further rise in oil prices would push up prices further. Coupled with higher interest rates, this could stop the economic growth momentum in its tracks and upset RBI's fine balancing act. Other worries like slowing global growth, rising interest rates across the globe, etc, are significant but not threatening, at least as of now.

Managing the asset price bubble
The RBI is acutely aware of the asset price inflation caused by the low interest regime which prevailed over the last few years. The bank has identified four sectors of the economy for close supervision of bank exposures. Close supervision of bank exposures to real estate, capital markets, NBFC's and venture capital have already been initiated by the bank. Among these, real estate is considered to be the one area where there are early signs of a bubble.

To ensure better ability to manage the risks, the RBI has increased the provisioning requirement on standard assets from 0.25 per cent to 0.40 per cent. This provision is a general provision on all advances made by banks, except priority sector advances. Most PSU banks keep this general provision at the required level while some private banks maintain higher provisions. The increase in provisioning is expected to cost the banking sector an additional Rs800 crore.

Banks' exposure to capital markets
The RBI has changed the norms regarding banks' exposure to capital markets, a move which it said is part of a rationalisation process. Till now banks were allowed to have an exposure not exceeding five per cent of its total assets. Apart from direct exposure, bank advances to brokers and retail investors were also considered a part of this overall exposure.

Under the new guidelines, a bank's direct exposure to capital markets should be limited to 20 per cent of its net worth. Aggregate exposure, including advances to market participants, should not exceed 40 per cent of the net worth. RBI will continue to give a case by case approval to individual banks for increasing their capital exposure limits from these norms. In the past, some of the leading private sector banks had received this approval.

The initial reaction to the new guideline was that it would facilitate more liquidity flows from the banking sector into the capital markets, which would be contrary to the policy stance of the RBI. The aggregate exposure limits under the new regulations would not significantly higher than the earlier limits.

In any case, most of the banks have been reluctant to increase their exposure to the capital markets. The exposure of PSU banks was much lower even under the earlier regulations. The experience of Global Trust Bank, which had capital market exposures way beyond the prescribed norms, serves a cautionary note.


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RBI credit policy: Refocusing on inflation