Demystifying the RBI Credit Policy...

Repo rate @ 7.75%;
Reverse Repo @ 6.0%;
Cash Reserve Ratio @ 7.5%;
Bank Rate @ 6.0%

The RBI left its benchmark interest rates unchanged in its monetary and credit policy review announced on January 29th 2008. The markets were disappointed as they were expecting a rate cut in the benchmark interest rates. The stock markets also felt the shudders and interest rate sensitive stocks in the banking, auto and real estate sector were down between 3.0-6.0% since the announcement.

Since October 2004, Indian interest rates have been on an upward journey with the Repo rate higher by 1.75% and the CRR up by 3.0%. So it is worth noting that this was the first instance since 2004 when the markets expected a rate cut. The rate cut expectations gathered further steam after the U.S. Fed cut the fed funds rate by 75 bps on 22nd January. The Fed cut a further 50 basis points on January 30 to leave the funds rate at 3.0%, a full 225 bps lower than its September 2007 high of 5.25%.

It would be difficult for global central bankers to follow the U.S. Fed in the extent of rate cuts. The US is going through a series of problems – financial market crises with losses threatening to erode banks’ net worth, loss in consumer wealth and spending power due to a fall in real estate values and the possibility of an economy slipping into recession. The US Fed has thus clearly chosen growth and financial stability over inflation.

It is a well accepted fact that global growth would slow down in 2008 (primarily due to the financial market crisis and a US recession) and global interest rates would reflect that eventuality. But the interest rate cuts in other countries are likely to be gradual and very cautious of inflation and money supply growth.

The RBI also seems to be in the same camp – It is more concerned about inflation and is not in any hurry to ease rates. In its policy document, it has repeatedly referred to the risks of higher inflation.

Although inflation (as measured by the Wholesale Price Index) looks benign, it is all set to inch upwards. The base effect in the coming months should take the headline inflation to around 4.1-4.2%. The area under Rabi sowing was lower by 3.0% from the previous year. Add in the impact of higher minimum support prices for wheat and other agricultural products; and food inflation could be a whole lot higher. Most food products are already higher by 20-25% since last December. High oil prices have also become more of a permanent feature in the global economy and it is about time our prices adjust to the reality. We expect a hike of 5.0%-10.0% in retail oil prices and this itself should add around 30-40 bps to inflation.

A key question is whether interest rates in India have peaked. Market interest rates had peaked some time ago. They had touched a high in August and have fallen quite sharply since then.

The answer lies in the volatility in the money markets in the previous year. In such a scenario banks have no clear view on its incremental cost of borrowing and hence are unable to price their lending rates. Also, the frantic expansion of deposits in the previous year meant that deposit rates had to be increased in order to sustain the growth. Banks have started to reduce their deposit rates only now and in the coming months some high cost deposits contracted last year are likely to be rolled over at a lower rate, reducing their overall cost of borrowing.

We expect meaningful reduction in lending and deposit rates after March, even without a rate cut by the RBI. It is realistic to expect lower rates in residential housing, auto, durables and business loans. Personal loan rates and loans on credit cards would remain higher as banks are witnessing increasing defaults in such high risk categories. Despite this, we do not expect rates to go down to the 2003-04 levels. If India continues to maintain a growth rate above 7%, bank lending activity would remain healthy and would keep interest rates at reasonable levels.

We still do not expect the RBI to cut benchmark interest rates aggressively. The RBI has enough liberty in the CRR, SLR and MSS balances to infuse liquidity into the system to keep interest rates steady if and so required. It would be interesting to observe the impact of the US led slowdown on Indian economic growth in the months to come.

Above article is authored by Quantum.

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