Rama Krishna Vadlamudi, HYDERABAD

June 17, 2011

As expected, the Reserve Bank of India has raised its benchmark Repo rate (under its Liquidity Adjustment Facility or LAF) by 25 basis points to 7.50 per cent when it announced the mid-quarter monetary policy on June 16, 2011. The new rate is with immediate effect. The Reverse Repo rate under LAF and the interest rate under Marginal Standing Facility are linked to Repo rate. As such, both the Reverse Repo rate and Marginal Standing Facility rate stand increased to 6.50 per cent (one per cent below Repo rate) and 8.50 per cent (one per cent above Repo rate) respectively with immediate effect.
Since the beginning of year 2010, RBI has been increasing the interest rates continuously. The latest Repo rate hike is tenth increase since March 2010 when RBI increased Repo rate from 4.75 per cent to 5.00 per cent the cumulative increase in Repo rate amounts to 275 basis points (or 2.75 per cent) in the last 15 months.

Rationale
What is the rationale behind RBIs latest increase in rates? Inflation rate of 9.1 per cent (provisional figure) remains at highly uncomfortable levels due mainly to high commodity prices Non-food manufactured goods prices have gone up in May 2011 in addition to higher inflation of food articles Manufacturers are passing on the increase in wage cost and service cost to consumers as is evident in the inflation indices Private consumption is at higher levels even though there is some deceleration in some sectors, like, automobiles

Rama Krishna Vadlamudi, HYDERABAD

www.scribd.com/vrk100

June 17, 2011

vrk_100@yahoo.co.in

MY BLOG: www.ramakrishnavadlamudi.blogspot.com Impact

The present rate hike from RBI is on the expected lines. The stock market as well as the bond market has weakened considerably well before the announcement of the RBIs rate hike. In its Annual Policy announced on May 3rd this year, RBI raised the Repo rate by 50 basis points in one go. After the Annual Policy announcement, commercial banks were quick to increase their lending rates suggesting strong monetary policy transmission, which indicates the ability of the RBI to pass on its policy initiatives to the broader economy. On June 16, 2011, the benchmark Sensex closed at 17,986 down 0.81 per cent over the previous days close and the Nifty was down at 5,397. The downtrend is likely to continue till the next policy announcement by RBI. One can expect Sensex to drift down another 10 per cent from the current 18,000-level. The bond market too had been reacting negatively in the last six weeks or so to the expected increase in RBI rate hikes. The benchmark 7.80 per cent 10-year Government of India security maturing in 2021 was showing signs of weakness till the policy announcement yesterday. But, after the rate hike announcement mid-day, the bond prices have gone up and the benchmark papers yield declined to 8.30 per cent from 8.38 per cent the previous day (bond prices move in opposite direction to bond yields). The future for Government bond prices looks weak now. Commercial banks have been enjoying good net interest margins. As such, they may absorb some of the present rate hike themselves while some portion of the burden will be passed on to borrowers. Banks may increase their deposit rates also depending on the credit offtake. Overall, borrowers can expect rate increases in home loans, car loans, coporate loans, etc. This in turn will adversely affect domestic consumption.

Outlook
It is not clear whether the RBIs actions in the last 15 to 18 months have been able to contain inflationary expectations even as GDP growth rate has moderated to 7.8 per cent in the January-March 2011 quarter from 9.4 per cent in January-March 2010 quarter. There is visible slowdown in manufacturing as indicated in the Industrial Index of Production (IIP). In the month of April 2011, IIP is at a sober level of 6.3 per cent. However, the apprehensions regarding the effectiveness of monetary policy in containing growth-induced inflation remain unanswered at this point of time. Diesel price may be increased by the Government as the fiscal deficit may go out of control this year due to higher cost of imported crude oil. The subsidy burden of diesel, LPG and kerosene is too heavy for the Government. The liquidity situation seems to be comfortable now. Credit growth is around 21 per cent year-on-year above the RBIs indicative projection of 19 per cent. The monsoon is most likely to be normal this year providing some hope on the food inflation front.

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Rama Krishna Vadlamudi, HYDERABAD

www.scribd.com/vrk100

June 17, 2011

vrk_100@yahoo.co.in

MY BLOG: www.ramakrishnavadlamudi.blogspot.com
With stock markets languishing in sideways to downward trend, it remains to be seen whether the Government will be able to go ahead with its disinvestment programme. If it fails to raise additional money through disinvestment, its hold on the fiscal situation will deteriorate leading to higher fiscal deficit. Higher fiscal deficit may translate into higher interest rates in future. If the Government increases diesel prices, it may further accentuate inflationary expectations in the economy. The financial markets have been expecting another rate hike of a minimum of 50 75 basis points before the end of this fiscal year. However, what needs to be emphasized is that RBI will be keenly watching the important data, like, inflation, GDP growth, tax collections, disinvestment of public sector companies, oil prices, global cues, and others, before making further moves on its fight against inflation monster. In the last 15 months, RBI has been increasing interest rates as per market expectations as inflationary pressures have been building up in the economy. But the same cannot be said for the future RBIs moves on interest rates. Next time, we need to expect the unexpected from RBI. Even though many experts and analysts have been expecting 50 to 75 basis points increase, we need to keep our fingers crossed and keep a close eye on data.

Repo rate: The overnight rate at which banks borrow money from RBI by pledging Government securities with RBI Reverse Repo rate: The overnight rate given by RBI to banks when the latter keep their surplus funds with RBI (one per cent below Repo rate) Marginal Standing Facility (MSF): Banks can borrow overnight from the RBIs MSF up to one per cent of their respective net demand and time liabilities or NDTL. The rate of interest on amounts accessed from this facility will be 100 basis points (one per cent) above the repo rate. LAF RBIs Liquidity Adjustment Facility RBI Reserve Bank of India, LPG Liquefied Petroleum Gas GDP Gross Domestic Product or national income IIP Index of Industrial Production Disclaimer: The views of the author are personal. The author writes copiously on financial markets equities, bonds, currencies, taxes, Indian economy, etc. You can read these articles on: www.scribd.com/vrk100 or www.ramakrishnavadlamudi.blogspot.com

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