Interest rates set to rise

Interest rates set to rise, signals RBI
Prabhakar Sinha , TNN 28 October 2009, 01:52am IST

Interest rates are likely to start rising soon. This was clearly indicated by the second quarter review of the monetary policy, 2009-10, unveiled by RBI governor D Subbarao on Tuesday. Releasing the review, the governor said that in the light of mounting inflationary pressure, which is projected to touch 6.5% by March 2010, the monetary policy's first priority would be to contain the inflationary expectation.

The RBI left all major policy rates like repo and reverse repo rates — the rates at which it lends to and accepts money from banks respectively — and cash reserve ratio (CRR) — the percentage of deposits banks are supposed to keep with the central bank — unchanged. But it took the first step towards rolling back its easy money policies, pursued for the past year to counter the economic slowdown. It terminated special liquidity facilities like credit refinance limits extended to banks against the loans given to exporters and mutual fund companies ahead of the original March 31, 2010 expiry date.

The central bank also reversed its earlier decision to reduce the minimum required investment by banks in government securities from 25% to 24% of deposits. The statutory liquidity ratio is now once again 25%. As most banks have already invested more than 25% in government securities, this decision will not have an immediate impact on the availability of funds, but these measures clearly indicate the RBI's intent to discontinue the accommodative monetary policy.

Responding to the measures, finance minister Pranab Mukherjee said that the RBI's assessment, on the whole, is in conformity with the government's thinking on both fiscal policy and monetary policy. However, he said the government would continue with the stimulus packages till the economy is back on a firm recovery path. Mukherjee also disagreed with RBI's projection of 6% economic growth with an upward bias for 2009-10. He said he would prefer to go with the growth projection of 6.5% to 6.75% given by the prime minister's economic advisory council in its mid-year review.

In the light of inflation rising to 6.5% by March 2010, the central bank will be left with little choice but to raise the policy rates. With the rise in the inflation, the net interest rates of all the policy instruments will become negative. In that situation, Subbarao said, the central bank will use its monetary policy rates to anchor the inflationary expectations in the country. Keeping this in mind only, he said, the money supply target has been reduced by one percentage point to 17%. However, he was quick to add that exit of the easy money policy will be calibrated in such a fashion that while the recovery process is not hampered, inflation expectations remain anchored.

He further hoped that with the new prime lending benchmark system likely to be introduced soon, the lending rates would become more transparent and competitive. This would make the banks lend at lower rates with lesser margin over the cost of funds.

Global investment banker, Goldman Sachs, said that in its second quarter review statement the central bank, in fact, has reversed its priorities from the first quarter review statement made in July, when reviving the growth was the first priority.

The governor, however, maintained that inflationary pressure is mainly coming from the rise in prices of food articles due to supply constraints, which cannot be influenced much by monetary policy. But, in its policy statement, the central bank said, ``Even though the current inflationary pressure are driven by food prices, they can strengthen expectations of higher inflations and lead to generalized inflation.''

The governor also expressed his concern over rising asset prices, which could be because of surplus liquidity in the system. In the statement, he said, ``There is already some evidence of excess liquidity feeding through asset prices with potential financial stability concerns. In this background, bankers feel that the central bank will soon resort to tightening of liquidity condition. The Nomura securities said that the central bank might increase CRR to mop up surplus liquidity by December 2009.

Therefore, the second quarter review, bankers felt, is in the direction to build a ground to pursue tight money policy in time to come.

Sources: Times of India