RBI HIKES REPO AND REVERSE REPO RATES
WHAT IS THE RATIONALE BEHIND RBI's MOVE AND ITS IMPACT ON FINANCIAL MARKETS
Rama Krishna Vadlamudi, BOMBAY March 20, 2010
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EXECUTIVE SUMMARY OF THE RBI’s RATE HIKES:
Just one month before the scheduled release of Monetary Policy for the next financial year 2010-11, Reserve Bank of India has given a mild surprise to the markets by raising policy rates. RBI will be announcing its Annual Policy on April 20, 2010. However, it has decided to act on the policy front one month before the Annual Policy. In a pre-policy announcement made on March 19, 2010, RBI has decided to raise repo and reverse repo rates (under LAF) by 25 basis points each to 5.00 per cent and 3.50 per cent respectively.
RBI is confident of the economy recovery in India. It is optimistic about the manufacturing sector, revival in the investment activity and robust GDP growth. However, WPI inflation at 9.9 per cent for February 2010 has spooked the RBI and it is highly concerned about inflation on three fronts – manufacturing, food and fuels. So, it has decided to act decisively this time and raised the policy rates.
The last time RBI raised the Repo rate was in July 2008 when it hiked it by 50 basis points to 9.00 per cent. Reverse Repo rate was last raised in July 2006 by 25 bp to 6.00 per cent. Subsequently, these rates were brought down and the last policy rate action by RBI was in the form of a reduction of 25-basis points each in Repo and Reverse Repo rates to 4.75 per cent and 3.25 per cent respectively in April 2009. (See the Table at the end). In January 2010, during the third quarter review of monetary policy, RBI raised CRR by 75 basis points in two instalments sucking out liquidity from the banks to the tune of Rs 36,000 crore.
All these measures taken together point to a gradual increase of interest rates by RBI. As such, we can expect some more rate hikes from the RBI in the next one year depending on the pace of GDP growth and inflation figures. Of course, capital flows in the form of FDI and FII also matter a lot. Bond markets may witness further weakness. Even stock markets are expected to react negatively on Monday. RBI has been trying hard to maintain a balancing act between GDP growth and containing inflation. The cost of funds for banks will increase. Depreciation in bond portfolios and fall in treasury profits will dent banks’ profitability. Moreover, banks have to pay interest rate of 3.5 per cent on daily product basis wef 1.4.2010. Real estate sector also will be impacted severely. The automobile sector also will be impacted to some extent. The rate hikes will be good news for savers, especially senior citizens who depend on interest income for livelihood. Corporate lending rates may gradually go up by 75 to 100 basis points in the next few quarters. Banks may decide to hike loan rates on housing and automobile next month, depending on their marginal cost of funds.
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Highlights of the RBI’s pre-Annual Policy action
With a view to containing and anchoring inflationary expectations in the economy, RBI had on March 19, 2010 announced the following measures:
to raise the repo rate under the Liquidity Adjustment Facility (LAF) by 25 basis points from 4.75 per cent to 5.0 per cent with immediate effect, and
to raise the reverse repo rate under the LAF by 25 basis points from 3.25 per cent to 3.5 per cent with immediate effect
LAF corridor (the difference between repo and reverse repo rates) remains unchanged at 150 basis points.
RBI, in its third quarter review of monetary policy announced in January 2010, raised CRR by 75 basis points in two instalments. Now, it has left the CRR unchanged at 5.75 per cent.
To Know about my analysis of the RBI’s Third Quarter Review of Monetary Policy, which was announced on January 29, 2010, JUST CLICK:
RBI's 3rd Quarter Review-Shift in Monetary Policy Stance
www.scribd.com/doc/26035796
IMPACT OF THE RBI’s MOVE TO RAISE
REPO & REVERSE REPO RATES
I. IMPACT ON LIQUIDITY:
RBI says liquidity in the system is adequate. Till last month, the banking system has enjoyed ample liquidity due to the easy and accommodative money policy adopted by RBI. Before the CRR was hiked by 75 basis points to 5.75 per cent, banks used to park more than Rs 1,00,000 crore in the Reverse Repo window of the RBI. After the CRR hike and advance tax payment, the figure had come down to just Rs 5,400 crore yesterday. In fact, banks borrowed Rs 400 crore, for the first time since April 2009, from the RBI through the Repo window on Friday. As such, we can expect the liquidity in the form of reverse repo to extinguish in the next few weeks and banks may start to use the Repo window more often to source short-term funds from RBI. Tight liquidity conditions will continue in the months to come.
II. IMPACT ON MONEY MARKETS:
Due to tightening of liquidity, money markets will become more active. One can expect gradual rise of call money rates by 25 to 100 basis points in the next few weeks depending on the demand for money. If credit offtake picks up, short-term rates may go up substantially. However, usually, the first quarter of every financial year witnesses weak bank credit growth. If bank credit does not pick up pace, call money rates may be in the range of 4.00 to 4.50 per cent next quarter. Returns from liquid mutual funds will go up gradually in the next few months.
To know about good liquid and money market mutual funds, JUST CLICK:
Good Liquid or Money Market Mutual Funds
www.scribd.com/doc/23073415
III. IMPACT ON BOND MARKET:
In a surprise move, bond markets rallied strongly two days before the announcement of RBI policy rate hikes. In the last two days, the yield on the 10-year benchmark G-Sec paper went down by 17 basis points (Bond prices and yields have inverse relationship – when yields go down, bond prices go up and vice versa) and at the end of Friday, it ended at 7.83 per cent. After the closure of markets, RBI announced the rate hikes. So, we can expect the benchmark G-Sec rate to go up by 10 to 15 basis points on Monday when bond markets open. And by the end of April 2010, the 10-year benchmark yield may go up to 8.30-8.50 per cent. In this regard, the announcement of auction calendar of government borrowing programme is very important. If the Government decides to borrow heavily in the first half-year, we can expect further fall in bond prices. It is expected that RBI may further hike rates in next month during the Annual Policy.
IV. IMPACT ON STOCK MARKET:
Media has highlighted that the policy action from RBI is sudden and surprised the markets. CNBC TV18’s banking editor described the rate hike as “a sudden and stunning blow to the markets…” Even other non-business channels have speculated on the possibility of rate hikes in housing loan rates and auto loan rates. Such headlines in the print media will have a powerful impact on traders on Monday morning when markets open. We need to watch the headlines of print media on Saturday also to gauge the mood of the markets. If all of them are doing a chorus of rising interest rates, we can expect the stock market to fall by at least two per cent (Nifty 100 points down and Sensex with 350 points) on Monday morning. It’s a no-brainer that the real estate and banking stocks will be sold off heavily on Monday. Even another interest rate-sensitive sector Automobile may also be impacted to some extent. This will put an end to the post-Budget rally witnessed in the last three weeks. Sensex and Nifty witnessed positive closing at 17,578 and 5,263 respectively on Friday. However, the author feels the action from the RBI is well calibrated and any keen observer could have anticipated the RBI’s move.
Why did RBI act one month before the Annual Policy?
What is the rationale for RBI to act one month before the announcement of Annual Policy? RBI has decided to raise interest rates as part of a well-calibrated exit strategy initiated in the Second Quarter Review in October 2009 and carried forward in the Third Quarter Review in January 2010.
All indications from the growth front are that the economic recovery is consolidating. Both the GDP growth rates and industrial production point to this view. The manufacturing sector, especially, is doing well. The sharp rise in capital goods production is an indication of the revival in the investment activity. There is sustained pick up in demand for credit from both the banking and non-banking sources.
However, RBI is concerned about inflation – particularly in the manufacturing, food and fuel segments. The hike in fuel prices in the Budget 2010-11 has also added to the inflationary expectations. Inflationary pressures in the economy have accentuated spilling over to the entire economy. WPI inflation of 9.9 per cent for February 2010 has far exceeded the RBI’s projection of 8.5 per cent for end-March 2010. In fact, this latest inflation figure has unnerved the RBI. Further, RBI has cautioned that the WPI inflation may cross 10 per cent very soon. RBI is confident that the increasing capacity utilization and rising commodity prices will further feed increase in prices.
In this background, RBI has decided to hike the policy rates (Bank rate, LAF-Repo rate and LAF-Reverse Repo rate are called policy rates) one month before the schedule announcement of its Annual Policy for 2010-11 signalling another rate hike next month.
Several policymakers does not want to dub this as a withdrawal of stimulus, rather they would love to call it as a “normalization process,” a new word they designed for their latest actions as these financial systems seem to have come out of the crisis situation.
The timing is very important. There is a section of experts who think that the RBI is behind the curve, meaning while inflation and the growth rates are accelerating, RBI has not acted in full measure to contain the inflationary expectations in the economy. Policy action is lagging behind the important numbers, they think. In fact, RBI itself had admitted that ‘there are lags in monetary policy,’ while increasing the policy rates. RBI till now was reluctant to raise policy rates as it did not want to upset the growth prospects of the economy. After the WPI inflation reached almost double-digit and the industrial production figures indicated robust growth, RBI has decided to act decisively. It is confident that the economic recovery is consolidating.
Interestingly, RBI acted when liquidity is drying up after CRR rate hike by 75 bp in its third quarter review of the policy in January 2010. Mop up of funds through reverse repo auction has come down drastically as mentioned above.
Are housing loan interest rates likely to go up?
One interesting distinction here could be that public sector banks, as is their tradition and character, may not raise lending rates immediately due to certain factors inherent in the ownership pattern. However, private sector banks do not hesitate to raise their lending rates immediately after the policy rate hikes by RBI. This has been the experience for several years. So, we can expect immediate rate hikes from private sector banks, while public sector banks may play a ‘wait and watch’ game as is their wont. Corporate lending rates are likely to go up from April onwards. In the month of April 2010, one can expect housing loan rate hikes. In fact, many banks are closing their concessional loan rate schemes on housing loan by the end of this month.
Some voices from the Industry and Government on rate hikes:
HDFC: The rate hike decision by RBI may not have immediate impact on interest rates in the economy for housing loan rates. However, inflation is a concern. And depending on the inflation figures, there could be a slight increase in rates after a few months.
Indian Overseas Bank: Banks may hike their lending rates from April 1st onwards.
Bank of Baroda: BPLR hike is not likely in the near future.
Kaushik Basu, Chief Economic Adviser in the Ministry of Finance: RBI rate hike is only in small doses aimed at curbing inflationary expectations.
IDBI Bank: The rate hike is not a surprise at all
Can we expect another rate hike on April 20?
All indications are that there will be another rate hike on April 20, 2010 when RBI announces its Annual Policy for 2010-11. Depending on capital inflows and inflation figures, RBI may decide to announce another round of rate hikes (25 bp each) in the form of both the Repo and Reverse Repo as well as a hike in CRR. RBI will be looking at GDP numbers and tax collections, especially excise and customs. However, GDP growth was a little subdued in the third quarter of the current fiscal 2009-10. And it will be monitoring the progress of actions from other central banks, like, US Fed, BoE and ECB.
To read my article on Third Quarter GDP numbers, JUST CLICK:
India's 3rd Quarter GDP-Subdued growth rate for Oct-Dec 2009 qtr
www.scribd.com/doc/27675995
ABREVIATIONS USED:
BoE : Bank of England
BPLR : Benchmark Prime Lending Rate
CRR : Cash Reserve Ratio (the money banks have to keep statutorily with
RBI – RBI does not pay any interest on CRR money kept by banks)
ECB : European Central Bank
FDI : Foreign Direct Investment
FII : Foreign Institutional Investors
LAF : Liquidity Adjustment Facility (RBI uses this facility to withdraw
excess liquidity from banks or inject liquidity into banks when they
need it)
LAF-Repo Rate : The rate charged by RBI to banks for lending its overnight money to
banks under LAF
LAF-Reverse Repo Rate : The rate paid by RBI to banks for keeping banks’ surplus funds
overnight with RBI under LAF
RBI : Reserve Bank of India
US Fed : US Federal Reserve
WPI inflation : Inflation based on wholesale price index
POLICY RATE CHANGES BY RBI SINCE 2008
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EFFECTIVE CRR LAF-REPO LAF-REVERSE REPO
DATE % Change % Change % Change
10-Nov-2007 7.50 up 50 bp
26-Apr-2008 7.75 up 25 bp
10-May-2008 8.00 up 25 bp
24-May-2008 8.25 up 25 bp
12-Jun-2008 8.00 up 25 bp
25-Jun-2008 8.50 up 50 bp
5-Jul-2008 8.50 up 25 bp
19-Jul-2008 8.75 up 25 bp
30-Jul-2008 9.00 up 50 bp
30-Aug-2008 9.00 up 25 bp
11-Oct-2008 6.50 down 250 bp
20-Oct-2008 8.00 down 100 bp
25-Oct-2008 6.00 down 50 bp
3-Nov-2008 7.50 down 50 bp
8-Nov-2008 5.50 down 50 bp
8-Dec-2008 6.50 down 100 bp 5.00 down 100 bp
5-Jan-2009 5.50 down 100 bp 4.00 down 100 bp
17-Jan-2009 5.00 down 50 bp
5-Mar-2009 5.00 down 50 bp 3.50 down 50 bp
21-Apr-2009 4.75 down 25 bp 3.25 down 25 bp
7-Nov-2009
13-Feb-2010 5.50 up 50 bp
27-Feb-2010 5.75 up 25 bp
20-Mar-2010 5.00 up 25 bp 3.50 up 25 bp
NOTES: bp - basis points
1. SLR changed on 8.11.08 for the first time since 25.10.97 and again restored to 25%
during second quarter review of annual policy on 27.10.09.
SLR was reduced by 100 bp to 24% wef 8.11.2008.
2. Bank Rate has been at 6% since 30.04.2003
3. LAF-Reverse Repo rate has been at 6% between 25.07.2006 and 07.12.2008
4. Savings Bank rate has been at 3.5% since 01.03.2003
5. Strictly speaking, Bank Rate, LAF-Repo and LAF-Reverse Repo rates are called
Policy rates; whereas CRR and SLR are known as Reserve Ratios
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