India's Central Bank Enters Defense Mode

The newspaper headlines the day after Reserve Bank of India (RBI) [India's central bank] governor Y.V. Reddy announced the credit policy review of July 29 said it all: "Reddy swaps growth for inflation," read the Hindustan Times. "Reddy junks growth to beat inflation," reported the Daily News & Analysis.

Bankers, who usually appear neutral on RBI decisions, are following suit with their own candid policy appraisals. "The message is clear that tackling inflation is the number-one priority," says Gautam Vir, managing director and CEO of Development Credit Bank (DCB) [a private sector bank in India]. "These hikes are a clear signal to the market to constrain growth of credit as well as to hike lending rates."

The hikes that have stirred things up are in the repo rate, the rate at which the RBI lends funds to banks, from 8.5% to 9%, and the cash reserve ratio (CRR), the proportion of their deposits that banks have to set aside with the RBI, from 8.75% to 9%.

The first measure makes loans expensive. It will impact industry expansion plans and hurt bottom lines. At an individual level, it will increase the EMI (equated monthly installment) payments of homeowners who have mortgages on floating rates of interest. According to finance experts, this will result in demand for consumer loans tapering off and will choke the retail financing boom on which Indian financial institutions and banks have been riding the past few years. The CRR hike, which squeezes liquidity out of the system, will eventually have a similar effect, they say.

"The two-pronged approach of the RBI to hike interest rates and simultaneously sterilize liquidity may be considered strong measures to meet the policy objectives," says G.V. Nageswara Rao, managing director of IDBI Fortis Life Insurance. "Clearly inflation control remains the top priority, and both CRR and repo rate hikes seek to curb credit growth and correct the short-term debt yield curve," adds Sudip Bandyopadhyay, CEO of Anil Ambani Group-owned Reliance Money. "However, GDP growth will suffer as a consequence of this monetary tightening."

Necessary Measures or Overkill?

What has left bankers and market watchers unnerved is the size of the hikes. Consensus was that the repo rate would go up 25 basis points (bps; 100 bps is the equivalent of one percentage point). There were even some optimists who suggested that Reddy would not tinker with rates. In the credit policy announced at the end of April, the RBI had kept the repo rate unchanged and raised the CRR by 25 bps. However, in an unscheduled intervention in June, the central bank raised the repo rate by 50 bps and the CRR (in two stages) by 50 bps.

"The RBI believes that demand has not yet slowed down enough and monetary tightening to curb aggregate demand is still necessary. The policy has focused on getting money supply growth under control, which implies that credit growth will be brought down," says Ajay Srinivasan, chief executive of financial services for the Aditya Birla Group. "We can now expect the hike of 50 bps in the repo rate to be passed on to borrowers, impacting the profitability of the top 100 companies to the extent of 70 to 80 bps on average. The key question is whether in order to achieve the inflation target, this may curb growth beyond what is prudent."

Inflation, at a 13-year high of around 12%, is clearly beyond the RBI's comfort level. Just a few months ago, that level was 5% to 5.5%; since mid-February 2008, the actual figures have been above that. The government had taken a series of measures earlier, including export bans, reduced import duties and price controls. (See "Reading the Future of India's Economy") But so far, these efforts have not helped.