Fore-Warning Hardening of Interest Rates

Dr.N.A. Mujumdar,
Former Principal Advisor, Reserve Bank of India

On the face of it, the monetary policy package, announced by the Reserve Bank of India (RBI) Governor Dr. Y.V. Reddy, on April 18, 2006 appears to be designed to maintain the status quo.

1. The Bank Rate remains unchanged at 6 per cent;
2. The reverse Repo rate remains unchanged at 5.5 per cent, and the fixed Repo rate will continue to be 6.5 per cent;
3. The Cash Reserve Ratio (CRR) will continue to remain at 5 per cent; and
4. The interest rate on savings bank deposits regulated by RBI remains unchanged at 3.5 per cent. However, going by these formal indicators, it should be a mistake to dismiss the announcement as a non-event.

Three Worrying Features

The run-away expansion of credit and the tightening of liquidity in the banking system had led to market expectations that there would be some hardening of interest rates. Non-food credit was the key driver of banking activity, rising by 37.3 per cent in 2005-06, close on the heels of a rise of 27.5 recorded during the previous year. Credit growth outpaced deposit growth by a substantial margin. The year-on-year incremental non-food credit-deposit ratio continued to remain high at 113 per cent during 2005-06, as compared with 117 per cent a year ago. More importantly, the incremental non-food credit-deposit ratio jumped from 90 per cent in the first half 2005-06 to 132 per cent in the second half of the year.

There were pressures on the liquidity of the banking System; the redemption of India Millennium Deposits (IMD) at end-December 2005 drained liquidity to the extent of Rs. 32,000 crore. In fact RBI had to inject liquidity during the subsequent period: daily injections of liquidity under the Liquidity Adjustment Facility (LAF) averaged Rs. 11,686 crore during January-March 2006.

Money Supply (M3) also accelerated to 20.4 per cent in 2005-06, from an increase of 12.1 per cent during the previous year. What is interesting is that despite these three worrying features, namely runaway expansion of bank credit, tighter liquidity and larger expansion in money supply, inflation continued to be contained within a reasonable band Inflation measured by variations in the wholesale prices index (WPI), on a year-on-year basis, was 4 per cent at end-March 2006, compared to a peak of 6 per cent reached on April 23, 2005. Perhaps this remarkable performance in the area of management of inflation by RBI provides the key to why Governor chose not to hike interest rates in his April policy pronouncement.

Fore-Warning about Inflation

Let there be no mistake, Governor's address embodied in the highly analytical 73 page document entitled "Annual Policy Statement for the year 2006-07" fore-warns about higher inflation waiting to happen and which would logically lead to hardening of interest rates. In fact this forms the central message of the April monetary policy package.

Containing Inflation

Two distinct aspects of inflation management need to be spelt out in this context. First, inflation potential has been suppressed for the time being but which may manifest itself fully any time in the future. The second element in the configuration of demand pressures is that asset prices in housing, equity and bullion have continued to accelerate. Surveillance over exposure limits of the banking system in respect of sectors such as equity markets has already been stepped up; and risk weights for calculation of capital adequacy have been increased in respect of housing and real estate. The April measures further reinforce efforts in this direction.

In terms of potential inflation, as a matter of policy, we have not allowed international oil prices to be fully transmitted on to the domestic oil prices. In this context we can do no better than quote the following sentence from Governor's statement. "The incomplete pass-through to the prices of domestic petroleum products, particularly kerosene, liquefied petroleum gas (LPG), and to a small extent in petrol and diesel, appropriate timing of administered price increases into the retreating phase of inflation during the first half of 2005-06 and some burden sharing by oil companies as well as through customs/excise duty reductions mitigated the immediate cost push impact of international crude prices" (page 10). International oil prices, have continued to rise and one sees little hope of their returning to normal levels. We may thus be forced to permit their full transmission to domestic prices.

The openness of the Indian economy has also meant that we have to assign more weight to global factors while formulating monetary policy. To quote the Governor again: "The adverse consequences of further escalation of international crude prices and/or of disruptive unwinding of global imbalances are likely to be pervasive across economies, including India. Moreover, in a situation of generalized tightening of monetary policy, India cannot afford to stay out of step" (page 39). The message is thus loud and clear: We are poised to move over to a high interest rate regime.

The other set of measures of increasing general provisioning requirement on standard advances in specific sectors, namely personal loans, loans and advances qualifying as capital market exposures, residential housing loans beyond Rs. 20 lakh and commercial real estate loans - points to the same direction of upward movement of interest rates. Such provisioning requirement has been raised from the present level of 0.4 per cent to 1 per cent. More recently, property prices in metros and even in smaller towns have shown an alarming rise. To moderate such a rise RBI has increased the risk weight on bank's exposures to commercial real estate from 125 per cent to 150 per cent. It may be recalled that in July 2005, this risk weight had been raised from 100 per cent to 125 per cent.

Within a fortnight of the credit policy announcement, the higher provisioning requirements have resulted in the hike in lending rates. State Bank of India has hiked interest rates on home loans by 25 basis points with effect from May 1, 2006.

Moreover, the run-away expansion of credit has also driven banks to seek to mobilize larger deposits by offering higher deposit rates. State Bank of India has also raised the deposit rates by 50 basis points. This means the cost of funds to the bank would rise and hence the SBI has raised the Benchmark. Prime Lending rate by 50 basis points to 10.75 per cent. Perhaps other banks were waiting for the SBI to take the lead and there would be a general rise in interest rates. Major housing finance companies are already contemplating to raise their interest rates on home loans. HDFC has raised interest on home loans by half-a-percentage point and its Prime Lending Rate from 11.25 per cent to 11.75 per cent.

Can these rises in interest rate in specific segments be taken as a forerunner of the general hardening of the interest rate regime?

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