Mumbai, Oct. 29: Will Yaga Venugopal Reddy raise interest rates for the fourth time this year' Or, will he prefer to hold his hand and give the surging economy the chance to burgeon some more'
The questions hang in the air as Reddy and his coven of central bankers sit down on Tuesday to make a mid-term review of the Reserve Bank of India’s annual policy statement for 2006-07.
With just a day to go before the crucial decision is taken, the banking industry is riven: one group believes the RBI will raise the reverse repo by 25 basis points to tame inflation while the others reckon that wisdom will prevail and the central bankers would not want to poop the growth party.
Both factions have their arguments ready to buttress their theories, but the recent developments have given a slight edge to those who predict that the reverse repo rate will be revised to 6.25 per cent.
The reverse repo — the short-term interest rate at which the RBI sucks funds out from the banking system — has increasingly been used as a rate signaller. It has been raised three times since mid-January by 25 basis points at very rise. After a surprise rate hike in June, Reddy had tweaked it up further on July 25 after the first-quarter review of the monetary policy.
Inflation is the biggest worry that the central bankers have flagged continually at every review meeting. It’s no different this time: with inflation peaking to a four-month high of 5.26 per cent, the furrows will deepen as inflation nudges up to the top-end of the 5 to 5.5 per cent range that the Reserve Bank has projected for this fiscal ending March 31 next year.
The surge in inflation has prompted one set of bankers to believe that the central bank will raise the reverse repo for the fourth time this year in a bid to hold inflation within the targeted range.
“In the past, the RBI has shown how it is focused on targeting inflation by raising rates. The recent rise in inflation should, therefore, prompt the central bank to raise the reverse repo again,” says the treasury chief of a private sector bank.
A report by Edelweiss says continued high demand could see the annual inflation rate rise to nearly 6 per cent by December.
Rate hike signals
The surge in inflation isn’t the only reason that is cited by the proponents of the rate hike theory. Bankers and bond market circles also point out towards certain developments on the domestic front that set the stage for the fourth rate hike this year.
Firstly, there has been a strong growth in money supply. It is estimated that the growth is now to the tune of 19 per cent, far above the 15 per cent target of the central bank.
“There is a huge growth in money supply which builds up inflation. In such a case, too much money chases too few goods. Therefore, though we do not now have supply side shocks, there are demand pull factors that could lead to higher inflation,” says Rupa Rege Nitsure, chief economist with Bank of Baroda (BoB).
Adds Tarini Vaidya, country treasurer at Centurion Bank of Punjab, “Continued strong economic growth may give rise to demand side inflationary pressures in future. In the coming months, the benign influence of the base effect will also wear off, thus pushing up inflation above current levels. M3 growth for the full year is estimated at 20 per cent, which is significantly higher than the RBI’s target of 15 per cent, and may be a cause for concern to the regulator.”
Besides the 19 per cent growth in money supply, analysts say higher credit offtake could prompt the RBI governor to raise rates. Credit growth continues to be over 30 per cent, which is also above the central bank’s estimate of 20 per cent for the year.
“If the central bank does not raise interest rates, there is an impression that loanable funds will be available at cheap rates. Banks may, therefore, continue to over-lend. In such a scenario, the RBI has to raise interest rates to slow down the credit growth,” adds another analyst.
Incidentally, these ‘disturbing signs’ on the home front were stressed by the RBI in its previous monetary policy review. In July, it warned that money supply, deposit and credit growth were running well above the indicative projections, warranting caution by all concerned.
The Reserve Bank had then said there were demand pressures in the domestic economy alongside supply pressures such as high oil prices. It added that high credit growth, which exceeded growth in deposits, could exert upward pressure on prices when associated with supply shocks such as from oil. “These pressures have the potential to impact stability and inflation expectations,” it had cautioned.
However, for those who support a status-quo theory, high credit growth should not necessarily mean that the central bank would raise rates. “The RBI can also slow down credit growth to those sectors where it perceives a bubble forming by taking various prudential measures. Why should it raise interest rates for the system as a whole'” asks a director of a public sector bank. He adds that though inflation may be high, it is also manageable.
Bankers add that there are other reasons as to why Reddy will not raise rates this time. First, crude oil prices have softened in recent times and other central banks, including the US Federal Reserve, have opted to keep their rates steady.