Reddy on liquidity watch

Repo rate hiked to 7.25%; Banks, firms can borrow more abroad.

The Reserve Bank of India today hiked the repo rate by 25 basis points to 7.25 per cent but left the reverse repo rate unchanged. The repo rate is at which the RBI provides liquidity to banks.

The RBI drains funds from the banking system at the reverse repo rate, currently pegged at a four-and-a-half-year high of 6 per cent.

In its monetary policy review, the RBI announced a slew of measures to liberalise capital account transactions and deepen the debt and foreign exchange markets.

This follows the Tarapore committee report on fuller capital account convertibility and Prime Minister Manmohan Singh's observation on the state of the Indian debt market.

The hike in repo rate is likely to lead to a rise in short-term interest rates if high credit growth persists and liquidity comes under strain.

The RBI also revised its GDP growth forecast to 8 per cent in 2006-07 from the 7.5-8 per cent projected in April 2006 but retained the inflation target at 5-5.5 per cent for the year.

The policy statement refers to some indications of demand-driven inflationary pressures and possible spillover into inflation expectations, but concludes "there is no conclusive evidence of overheating".

There is no change in the policy stance, which continues to ensure "appropriate liquidity" to meet all "legitimate requirements of credit for productive purposes".

However, the undertone is more hawkish than expected and suggests possibilities of an imminent rate hike. The policy statement unambiguously says the RBI will "consider promptly all possible measures as appropriate to the evolving global and domestic situation".

Moving towards fuller capital account convertibility, the central bank included doubling of the ceiling on external commercial borrowings by banks to 50 per cent of their Tier 1 capital from 25 per cent.

It also gave permission for corporates to raise additional external commercial borrowings of $250 million with average maturity of more than 10 years under the approval route and to prepay up to $300 million without the RBI's prior approval.

Mutual funds' overseas investment limit has gone up to $3 billion from $2 billion. The RBI has liberalised remittances by corporates, allowing companies to remit up to 15 per cent of their average annual turnover during the last two financial years or up to 25 per cent of their net worth, whichever is higher, for initial expenses and remittances up to 10 per cent of the average annual turnover for recurring expenses.

The prudential limit on credit and non-credit facilities to Indian joint ventures/wholly owned subsidiaries abroad has been raised to 20 per cent of unimpaired capital funds.

Foreign institutional investors (FIIs) have been allowed to re-book a part of cancelled forward contracts. While this will add depth to the foreign exchange market, the debt market will benefit from the RBI move of raising the ceiling on FII investments in government securities to $3.2 billion by March 31, 2007, from $2 billion now. It also allowed short-selling in gilts for up to five days.

Apart from markets, banks and corporations, individuals, too, have been taken care of by the policy.

The ceiling on investments by individuals overseas has been doubled to $50,000 and the lock-in period for sale proceeds of the immovable property credited to non-resident rupee accounts has been eliminated, provided the amount being remitted in any financial year does not exceed $1 million.