According to economists, the hike in key rates will lead to a rise in cost of funds for banks and eventually make loans expensive, which in turn will reduce consumption

Continuing with its policy to modify policy rates in small percentage points, the Reserve Bank of India (RBI) on Thursday raised the short-term lending rate by 25 basis points (bps) and borrowing rate by 50bps. The latest hike, fifth in a row this year, in key policy rates will make loans expensive.

According to a PTI report, Bank of Maharashtra's chairman and managing director Allen Pereira said, "(The) rate of interest may have to go up. Banks have to take a view at the end of the quarter. Till 30th September, I do not expect any change. Pressure is there to increase rates in the near term."

The new rates, which come into effect immediately, were announced as part of the first scheduled mid-quarterly review of the monetary policy. According to economists, the hike in key rates will lead to a rise in cost of funds for banks and eventually make loans expensive, which will in turn reduce consumption.

"With the central bank raising the repo rate by 25bps to 6% and the reverse repo tender rates by 50bps to 5% in the latest policy review, borrowing rates will go up for consumers as well as for developers. For the projects that are already priced high, the impact in terms of demand erosion will be higher. We don't see much impact on low-ticket sizes, i.e., Rs25 lakh-Rs50 lakh purchases," said Shobhit Agarwal, joint managing director for capital markets, Jones Lang LaSalle India.

He said, "End-user demand will remain intact. Investors in residential and commercial premises will find lesser arbitrage opportunities as the cost of funding purchases becomes higher. Banks will revise housing loan rates upwards. As for funding to developers, this will not be seriously compromised apart from the cost of borrowing going up."

Some economists feel that the central bank is close to take a pause in its rate-hiking cycle.

"With monetary conditions tightening and global demand still sluggish, we retain our view that growth and inflation are likely to moderate in the coming quarters and that the RBI is close to pausing in its rate-hiking cycle," said Nomura Financial Advisory and Securities (India) Pvt Ltd in a note.

Echoing the same view, Indranil Sen Gupta, economist, DSP Merrill Lynch (India) said, "We continue to expect the RBI to pause after hiking the LAF reverse repo rate by 25bps on 2nd November with inflation peaking off - because inflation will likely come down to 7% by December and 5.7% by March 2011."

"The focus of RBI policy will need turn, sooner than later, to injecting liquidity to fund loan demand. After all, deposit growth, at 14.4%, is trailing 20% credit off-take at a time of a high 8.2% of gross domestic product (GDP) fiscal deficit and a 2.9% of GDP current account deficit," he added.

"In our view, real interest rates are likely to turn positive in India in late Q4, when inflation subsides to 6% or below by December 2010. In such an environment we believe inflation is unlikely to be the sole criteria for deciding monetary policy, as the underlying objectives of the RBI would be achieved," said Barclays Capital in a release.
Containing spiralling inflation which is hovering at double digits has been the RBI's top agenda. However, some analysts were thinking that taking IIP numbers alone into account, which have been quite volatile of late and have been revised downwards, the central bank may like to wait at least until the next policy meet for a more clear picture to emerge on the IIP growth front.

Kisan Ratilal Choksey Shares and Securities Pvt Ltd said in a note, "(The) market has already discounted a 25bps hike in both repo and reverse repo rates. Further, if RBI eschews raising rates this time it can always raise it any time either before or at the next policy meet."

While acknowledging that inflation remains the 'dominant' concern in policy management, the RBI said recent monetary actions have helped in generating early signs of a downturn in non-food manufacturing inflation. It noted that real interest rates are still negative, and the process of monetary normalisation may be deemed incomplete if this were to continue.

WPI inflation (new series) for August came in at 8.5% showing a sign of moderation against 9.97% a month ago. However, the index of industrial production (IIP) numbers for July bounced back to double-digit growth of 13.8% - significantly higher than the market's expectation of 8%-9% driven by strong growth in capital goods and consumer durables - each growing by 63% and 22%, respectively. The manufacturing sector grew by 15% while mining and electricity grew by 9.7% and 3.7%, respectively.

In its first ever mid-quarter policy review, the RBI has narrowed the corridor between repo and reverse repo rate to 100bps, indicating the central bank's desire to reduce volatility in the overnight call rate.

"We believe the Reserve Bank has finished raising the repo rate, but has left a small window open for further action on the reverse repo rate, especially given the priority of narrowing the corridor," said Barclays Capital.

Ramanathan K, chief investment officer, ING Investment Management India, said, "The 50bps hike in the reverse repo rate should not be construed as hawkish aggression given that we are moving into the busy season where liquidity would continue to be tight. The rate changes from now on will depend on evolving macroeconomic conditions - both domestic and global." 

Since October 2009, two considerations, normalisation of the monetary policy stance as the crisis abated and inflation management have driven the RBI's rate and liquidity actions. The central bank said it believes that the tightening that has been carried out over this period has taken the monetary situation close to normal.  

Though the RBI had raised the two key policy rates, it kept the bank rate, cash reserve ratio (the portion of deposits that banks are required to keep with the central bank) and statutory liquidity ratio or SLR, the portion of deposits that banks have to park in government securities, unchanged.