Time for a hike

The banking community is divided on the stance likely to be taken by the Reserve Bank of India governor, YV Reddy, when he unveils the mid-term review of the central bank's annual policy on October 25.

While the market is punting on a 25 basis point hike in short-term interest rates, there has been the equally strong view that the governor should leave the rates unchanged. On balance, it must be hoped that the governor will tweak rates up by another notch.

When the annual policy statement was presented in April, Dr Reddy faced two challenges: reining in inflationary expectations in the face of several uncertainties; and liquidity management in the context of the budgeted government borrowings and indications of strong credit growth.

He sought at the time to reflect inflationary concerns by increasing the reverse repo rate by 25 basis points to 5 per cent. In his first quarter review of the annual policy, Governor Reddy left the rates unchanged as, he said, "the balance of convenience" at that juncture lay in continuing with the status quo while monitoring the global uncertainties.

The mid-year review next week will have as its backdrop the new policy on the yuan and the rupee having lost 4 per cent against the dollar in the three months since the yuan lost its dollar peg.

Though there has been no substantial change in the outlook for global growth, and inflation remains under control, the risks have increased in recent months as international oil prices remain high and volatile. In response to an asset price boom, meanwhile, the US Federal Reserve has continued to hike its base rate, which now stands at 3.75 per cent.

For India, a rapidly growing current account deficit has put pressure on the rupee. At $6.2 billion in the first fiscal quarter, the deficit is only marginally lower than the $6.43 billion in all of the last year. The current account deficit by year-end could therefore reach $23-25 billion, or about 3 per cent of the GDP.

This, as well as the rupee depreciation, combined with the Fed's actions, has resulted in an outflow of portfolio funds in recent days as expectations of further stock market gains have waned. At the same time, credit growth continues to gallop along, and the government's chief economic advisor has endorsed the RBI's expectations of higher inflation, reaching 5-5.5 per cent by the year-end (from less than 4 per cent till the other day).

Each of these factors weighs in favour of a rate hike. Collectively, the case is compelling. Rates should be hiked when global rates are being raised (capital markets are linked, after all), when portfolio capital is flowing out, when inflation is expect to climb, and when rapid import growth is the cause of a historically large current account deficit.

The argument for leaving the status quo unchanged would hinge on not wanting to curb the momentum in the economy. The counter-view would also be that the net outflow of portfolio funds so far this month, at $128 million, is certainly not alarming, and that the European Central Bank has left rates unchanged while the Bank of England has actually lowered them.

Also, higher interest rates will put pressure on banks' bottom line as they revalue security holdings that are marked to market. The clincher from this point of view would be that, despite rapid growth, there is no sign of the system over-heating, especially after the stock market correction, and other countries have sustained much larger current account deficits during their rapid growth phase.

However, it is worth keeping in mind that while liquidity in the system continues to be comfortable, with the RBI drawing over Rs 15,000 crore worth of bank funds daily at its repo window, an estimated outflow on about Rs 35,000 crore on account of redemption of the Millennium Bonds in December will change the liquidity scenario. A 25 basis point rate hike is therefore what the governor should deliver.