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. ...