Inflation rates are climbing up
constantly, above 10% during the recent months, concurrently resulting in an increase
in the pricing power. To anchor the inflationary trends, the Reserve Bank of
India (RBI) has increased its key rates for the fourth time in the same year.
During the first quarter of 2010-11, RBI increased its repo rates to 5.75%, and
the reverse repo rates to 4.5%. Repo rates are the rates at which RBI lends
money, and reverse repo is the rate at which it borrows money from other banks.
Reverse repo rates act as a floor, and repo rates; as a ceiling.
When domestic banks are in
short of cash, and overnight call money rates are higher than the repo rate,
banks approach RBI for cash. Therefore, lending money under repo rates is an
effective policy tool, as it aids in minimizing rates in the overnight market. When
liquidity is tight, and banks require cash for a short term, repo rates are
useful. The reverse repo process occurs when money market rates fall below the
reverse repo rate. Hence, reverse repo is more effective, when there are
surplus funds with the domestic banks.
Non food items account for 70% of
the WPI (Wholesale Price Index). Recent increase in fuel and electricity is
expected to further push inflation rates higher in the short term. Raising the
reverse repo rates enable RBI to narrow the term for short term loans thus
reducing the volatility. RBI aims to keep the liquidity under control, and
further restrict excess liquidity from diluting the policy rate actions. The
bank also contemplates to increase its frequency of reviewing the monetary
policy. There would be 8 policy announcements in a year instead of 4. The next
review is planned during 16th September followed by the one in 2nd
Economists predict intermittent
liquidity tightness in the future, making the repo rates to remain as the
operative policy rate. This implies another 150 bps (basic points) of
tightening in the operative policy rates from reverse repo to repo rates over
the past two months. Though the liquidity is tight, RBI has left the Cash
Reserve Ratio (CRR) untouched at 6%. CRR is the compulsory amount of cash;
banks have to keep with RBI. This will increase the interest rates charged by
banks, thus putting pressure on the industries.
Some industry players are
pessimistic regarding the hike. They believe that the RBI decisions will result
in a rise in the lending rates. They fear that borrowing costs will go up, and
high borrowing costs will impediment business activities. Hike in lending rates
will add pressure on the loans by banks. The current credit market is
experiencing tightness, and interest hikes might further tighten the cash
availability in the market. While hike in rates are planned for curbing
inflationary expectations, it would not immediately limit the same.
RBI is currently attempting a
balancing act by managing the inflation and fostering growth rates at the same
time. It believes that narrowing the gap between the repo and the reverse repo
rates will make pricing easier in the market. One more hike in the rates is on
the cards for RBI with the next review planned for September. Optimistically,
it can be expected, the inflation would be under control by then.
1) The Economic Times, RBI raises key rates in war against inflation, 28th July, 2010.