The RBI rate change on Tuesday stuck to the consensus script. Well, almost. The market had widely accepted a 25 basis point rise in both the repo and reverse repo rates. RBI obliged in the former case bringing it to 5.75% and doubled the rise for the latter to raise it to 4.5%. It kept the third lever at its disposal, the cash reserve ratio (CRR) constant at 6% and announced that it will now review monetary policy twice as frequently by introducing mid-quarter reviews.
For the uninitiated, the repo rate is the rate at which RBI lends money to banks and the reverse repo is the rate banks can get by parking funds with RBI. Depending upon the phase of the cycle, action is usually restricted to one of the two rates. In other words, if demand for credit outstrips liquidity, banks need more money to lend and hence are more likely to borrow from RBI while in a surplus liquidity situation the reverse repo rate may be more relevant as banks park their excess funds with the central bank. Currently, the repo rate is the policy rate, with banks no longer flush with excess funds. Both are ?price instruments? in the sense that they regulate the amount of money supply in the economy by providing appropriate economic incentive to the banks. Changing the CRR, in contrast, is akin to a ?quantity measure? that just compels banks to park more funds with RBI (for an increase in CRR) and makes more funds available for lending (for a decrease).
To get some perspective, post-Lehman, RBI had slashed the repo rate from 9% to 4.75% and the reverse repo rate from 6% to 3.25%. CRR fell from 9% to 5%. Two years later, with the industry in anything but a slowdown and inflation in close competition with Maoists to be the government?s worst headache, it is hardly surprising that the clawing back is continuing. The ?calibrated exit? from the government stimulus continues, as it must under the circumstances. The rise in reverse repo just ensures that banks would not be tempted to push credit too heavily if credit demand drops. In that sense, RBI?s move had little effective surprise. While the chambers of commerce dutifully grumbled about a rate hike that the RBI move had little surprise is clear from a mildly positive stock market response. The rupee had already risen in anticipation of the announcement.
That is actually good news. In the ideal situation, central bank decisions should be predictable non-events, causing no major jerkiness in financial markets, particularly in normal times. RBI?s decision to make monetary policy reviews twice as frequent would help markets move in that direction.
As of now, odds are in favour of an encore of this a quarter later if not sooner as RBI has significant head room left to raise rates, predictions of India?s growth rates are being repeatedly revised upwards and inflation remains doggedly in double digits. The medicine administered is certainly mild enough to produce little side effects.
Whether it is strong enough to produce results on the ailment, is harder to say. The impact of monetary policy on goods prices, both in terms of sensitivity and lag, still remain unclear in India and rain gauges may have more to do with prices than interest rates. The RBI rate hike may have little to do with food inflation reigning at close to 15%, at least directly and immediately, but can have a more predictable impact on the non-food inflation, which, too, is in double digits and contributed as much as 70% to WPI inflation in June.
If RBI?s control over food price rise is tenuous at best, foreign capital flows may continue to further weaken its ability to even impact the cost of capital for firms. As the rates rise, India becomes ever more tempting to global investors. Foreign fund flows hit a 51-week high last week. The rupee rise is likely to continue. It is unlikely that firms with good projects would be anywhere close to being starved of funds. Just the source composition of those funds may change a bit.
Things are not looking good on the inflation side even though the rains have not been too bad so far. Close monitoring, of the economy and the rain-charts, and preparedness for quick intervention may be the prescription for RBI. The ?mid-quarter? review provides an opportunity for RBI to do just that without letting everyone go into a panic mode with an out-of-turn rate change. Surprises are hardly welcome in these days of ?unusual uncertainty?.
The author teaches finance at the Indian School of Business, Hyderabad