Reverse repo rate hiked by 25 bps

Repo rate hiked to 6.5%; GDP target raised from 7-7.5% to 7.5-8%.

The Reserve Bank of India (RBI) today increased the reverse repo rate by 25 basis points to 5.50 per cent as a "pre-emptive" response to stabilising rising inflationary expectations against the backdrop of higher-than-anticipated monetary and credit expansion.

The central bank also raised the repo rate by an identical margin to 6.5 per cent, maintaining the 100 basis points rate differential between the repo and the reverse repo rates. This makes it the fourth hike in short-term reverse repo rate over the last 18 months.

However, the main signalling device, the bank rate, has been left unchanged at 6 per cent. The RBI also did not concede bankers' demand for a reduction in cash reserve ratio (CRR) to release liquidity in the system.

The reverse repo rate is the rate which RBI pays to absorb liquidity from the banking system while it injects liquidity at the repo rate. Following the RBI measure, banks will have to pay more to avail of funds from the RBI.

In a knee-jerk reaction to the RBI measures, bonds prices fell and the yield on government securities went up.

Defending the rake hike, RBI Governor YV Reddy said a measured policy response at this juncture would stabilise inflation expectations and help the central bank avoid taking drastic steps later.

The policy document warned that "the step up in credit growth, movement in asset prices and growth in monetary aggregates pose further risks of potential inflationary pressures" and stressed that the pass-through of higher international crude oil prices to domestic fuel prices remained incomplete and could pose an upside risk to inflation.

For the rest of 2005-06, the inflation expectation remained unchanged in the range of 5.0-5.5 per cent, but RBI raised the GDP growth expectation for the year to 7.5-8.0 per cent from 7.0-7.5 per cent projected in October 2005 on the back of a pick-up in agricultural output and momentum in industrial and services sectors.

The overall stance of the monetary policy now is to maintain emphasis on price stability, support export and investment demand through a conducive interest rate environment and provide appropriate liquidity to meet genuine credit needs.

Reddy said the RBI would continue with its policy of active demand management of liquidity through open market operations (OMO), including market stabilisation scheme, liquidity adjustment facility and CRR. It will use all the policy instruments at its disposal flexibly, as and when the situation warrants.

Expansion in M3 (money supply) is expected to be significantly higher than 14.5 per cent projected in April 2005 and growth in aggregate deposits will also be much higher than Rs 2,60,000 crore projected earlier.

Similarly, non-food bank credit including investments in bonds and debentures is expected to be significantly higher than the target of 19 per cent.

Till January 6, the year-on-year growth in M3 was 15.9 per cent while aggregate deposits increased by 17 per cent (Rs 2,81,617 crore) and non-food credit growth was 32 per cent, its highest in 25 years.

"Assuming that current prices represent a permanent component, the need to align with international prices and the probability being assigned to higher crude prices in the year ahead imparts an upside risk to inflation in 2006-07. The step up in credit growth, movement in asset prices (including equities and real estate) and growth in monetary aggregates pose further risks of potential inflationary pressures," Reddy said.

The RBI noted that the recent developments in the balance of payments (BoP) seem to indicate that the Indian economy has entered an expansionary phase of the business cycle.

The current account deficit of the order of $13 billion in the first half of 2005-06 needs to be regarded as consistent with the scaling up of the growth path that has occurred in the current financial year.

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Reddy's pre-emptive medicine

ACTION

Reverse repo rate hiked by 25 basis points to 5.5%

Repo rate hiked by 25 basis points to 6.5%

CRR unchanged at 5%

Bank rate unchanged at 6%

GDP target raised from 7-7.5% to 7.5-8%

Inflation target unchanged at 5-5.5%

CONCERNS

Volatility in reserve money and upward pressure on money supply

Demand deposits growing faster than time deposits and CDs becoming key source for certain banks

Geopolitical tensions still threatening oil supply

Likely expansion in global demand for petroleum products

Global oil prices edging up and may remain high in 2006

MONETARY STANCE

Emphasis on price stability to anchor inflationary expectations

Conducive interest rate environment for supporting export, investment demand

Appropriate liquidity to meet credit needs with due emphasis on quality