Rama Krishna Vadlamudi, Hyderabad 16 September 2011 www.ramakrishnavadlamudi.blogspot.

com

As expected by the markets, the Reserve Bank of India has raised interest rates by another 25 basis points (0.25 per cent). The policy rate, that is Repo rate under RBI’s Liquidity Adjustment Facility, is increased to 8.25 per cent. Since March 2010, RBI has hiked interest rates by 350 basis points and that too twelve times in succession. However, markets had expected that RBI would tone down its stance on dear money policy. In its latest review, RBI has continued with its hawkish stance. Despite several rate hikes, the inflation rate – close to 10 per cent now – has continued to be stubborn even though GDP growth and industrial production growth are slowing down. What is complicating matters for RBI is yesterday’s decision by the Government of India to hike retail petrol prices by Rs 3.14 per litre – this is the third hike in retail fuel prices in this calendar year. The question on everyone’s mind is whether RBI will stop raising interest rates further. The RBI will be watching the macro economic indicators and global developments closely before making further moves on policy rates. RBI Policy Decision
The Repo rate (under its Liquidity Adjustment Facility or LAF) is the benchmark policy interest rate for the RBI. The RBI has raised its Repo rate by 25 basis points (0.25 per cent) to 8.25 per cent when it announced the mid-quarter monetary policy on 16 September 2011. The new rate is with immediate effect. The Reverse Repo rate under LAF and the interest rate under Marginal Standing Facility are linked to Repo rate. As such, both the Reverse Repo rate and Marginal Standing Facility rate stand increased to 7.25 per cent (one per cent below Repo rate) and 9.25 per cent (one per cent above Repo rate) respectively with immediate effect.

Rama Krishna Vadlamudi, Hyderabad 16 September 2011 www.ramakrishnavadlamudi.blogspot.com
Twelfth Rate Hike Continuously
Since March 2010, RBI has been increasing the interest rates continuously and the latest increase is twelfth in the series. The RBI’s Repo rate hikes started from 4.75 per cent and the rate is now at 8.25 per cent, an increase of 350 basis points. In the last decade, the highest Repo rate was 9 per cent that existed from the end of July 2008 till September 2008 when Lehman Brothers collapsed.
LAF-Repo rates %
9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 7.25 7.50 8.00 8.25

5.00

5.25

5.50

5.75

6.00

6.25

6.50

6.75

M ar .1 0

No v. 10

M ar .1 1

1

Source: RBI

Rationale for Rate Hikes
What is the rationale behind RBI’s latest increase in rates? Inflation rate of 9.8 per cent (for the month of August 2011 based on wholesale price index-WPI) remains at highly elevated levels for the past 11 months due mainly to high commodity prices and supply chain bottlenecks This calendar year, fuel prices have been increased by Government of India three times. Retail petrol prices have been increased by Rs 8 per litre in the last four months. The impact of the fuel price hike is yet to play out fully in the economy. Non-food manufactured goods prices too are rising

Impact
The present rate hike from RBI is on the expected lines. However, it was expected by the markets that the RBI would change its policy stance. Contrary to expectations, there is no change in RBI’s hawkish monetary policy. The stock markets were one per cent up seconds before the RBI’s rate hike. As soon as the RBI hiked the repo rate, the markets had suddenly collapsed and went into negative for a few minutes. But, later they recovered from their low levels and at the time of writing, the Sensex is at 16,990 and the Nifty is at 5,100. The bond market too reacted negatively, though in a mild manger, to the RBI rate hike. Seconds after the RBI rate hike, the yield on the benchmark 7.80 per cent 10year Government of India security maturing in 2021 is quoting at around 8.36 per cent from the old level of 8.32 per cent.

03

16 Se p. 11

17 Se p. 10

Ju n. 11 16

Ju l. 1 0

Ju l. 1 0

.1 0

Ja n. 11

27

03

M ay .1

Ap r

20

25

20

02

17

26

Ju l. 1 1

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Rama Krishna Vadlamudi, Hyderabad 16 September 2011 www.ramakrishnavadlamudi.blogspot.com
Banks will wait for some time to raise either deposit or lending rates – though one cannot rule out the possibility of some private banks raising interest rates immediately. Depending on liquidity conditions and various other factors, Banks will wait for some more time before taking the plunge. The overall impact of relentless increase in interest rates will be negative for the stock market as well the bond market.

Outlook on Further Rate Hikes
The macro economic indicators are presenting a mixed picture as of now. The first quarter GDP (April-June 2011) growth is at 7.7 per cent, showing a continuous decrease for the last six quarters. The Index of Industrial Production for July 2011 indicates that the overall industrial production has recorded a growth of 3.3 per cent, which is the lowest in 21 months. The investment cycle too has slowed down. The GDP estimates and IIP figures are clearly indicating that the growth rate in India is slowing down. On the contrary, the inflation rate remains at elevated levels. Food inflation too is not under control. The Government of India has raised fuel prices three times in the current calendar year. The higher fuel prices are feeding into inflation figures. The inference is that RBI wants to keep its primary focus on inflation control despite signs of GDP growth slowing down. RBI continues with its current hawkish stance. However, the apprehensions regarding the effectiveness of monetary policy in containing growth-induced inflation remain unanswered at this point of time. But, RBI claims that its rate hikes are having some impact on inflation, though not up to their expectations. Inflation seems to have been caused more by supply chain bottlenecks, substantial increases in personal wealth and huge Government spending in the last three to four years. The subsidy burden of diesel, LPG and kerosene is too heavy for the Government and to keep the fiscal deficit under control, it is raising fuel prices as India imports 82 per cent of its crude oil needs. It will take some more time for the fuel price to fully reflect in inflation figures. There is no significant cut in Brent crude oil prices in the last three months and the outlook for crude oil prices remains hazy. The Government’s disinvestment programme is in a limbo as it is not able to raise any money through selling of small stakes in government companies. Due to weak market conditions and doubts about getting attractive issue price, the Government has now postponed the stake sale in ONGC, the public sector oil company. The monsoon is good till now and is expected to be normal this year. However, what needs to be emphasized is that RBI will be keenly watching the important data, like, inflation, GDP growth, IIP numbers, fiscal deficit, crude oil & other commodity prices, global cues especially from the crisis-ridden euro zone and others before making further moves on its fight against inflation monster.

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Rama Krishna Vadlamudi, Hyderabad 16 September 2011 www.ramakrishnavadlamudi.blogspot.com
Important Terms Explained
Repo rate: The overnight rate at which banks borrow money from RBI by pledging Government securities with RBI Reverse Repo rate: The overnight rate given by RBI to banks when the latter keep their surplus funds with RBI (one per cent below Repo rate) Marginal Standing Facility (MSF): Banks can borrow overnight from the RBI’s MSF up to one per cent of their respective net demand and time liabilities or NDTL. The rate of interest on amounts accessed from this facility will be 100 basis points (one per cent) above the repo rate. LAF RBI GDP IIP – RBI’s Liquidity Adjustment Facility – Reserve Bank of India – Gross Domestic Product or national income – Index of Industrial Production

Disclaimer: The author’s views are personal. He has a vested interest in the stock markets and his views should be taken with a pinch of salt. He may change his views very fast without any notice depending on the market and economic conditions. His views should not be construed as investment recommendation. There is a risk of loss in equity investments. Investors need to consult their certified financial adviser before making any investment decisions.

Note on author: The author in an investment analyst and writes copiously on financial markets – equities, bonds, currencies, taxes, Indian economy, etc. You can read these articles on: www.ramakrishnavadlamudi.blogspot.com

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