RBI raises reserve requirements, holds rates

The Reserve Bank of India took steps on Tuesday to drain surplus cash from the banking system stemming from strong capital inflows, knocking bonds and stocks lower, but it left its key interest rates steady, as expected.
The Reserve Bank of India (RBI), still sounding a fairly hawkish note after five rate increases since June last year, raised the proportion of cash banks have to keep with it on deposit to mop up funds that could fuel inflation.
“Monetary expansion has to be curbed,” said Saumitra Chaudhuri, economic adviser at credit rating agency ICRA.
The central bank raised banks’ cash reserve ratio (CRR) to 7% from 6.50% with effect from August 4, the fourth increase announced since early December, taking it to its highest level since November 2001.
It also scrapped a Rs30-billion ($740 million) limit on its daily money market operations to drain cash from the system, enabling banks to park more funds with it.
The yield on the 10-year government bond spiked up 12 basis points to 7.87% soon after the decision on worries these measures would leave less cash to buy bonds.
The stock market shed its 1 percent gain in a few minutes after the decision, with banks and auto stocks hit particularly hard on concern that loan growth would fall, but the market rebounded strongly in afternoon trade.
The partially convertible rupee inched towards last week’s nine-year high of 40.20 per dollar after the decision.
The RBI left its key lending rate, the repo rate, unchanged at 7.75% and its reverse repo rate, at which it absorbs excess cash from banks, steady at 6%. The bank rate, used to price long-term loans, remained at 6%.
Other Steps
India’s move came a day after China, inundated with cash from its current account surplus, raised the level of deposits banks must hold in reserve for the ninth time in 13 months.
India’s banking system has been awash with cash in recent months due to robust capital inflows into Asia’s third-largest economy, particularly into the record-breaking stock market.
“Recent financial market developments in India and potential uncertainties in global markets warrant a higher priority in the policy hierarchy for managing appropriate liquidity conditions,” the RBI said in a statement.
It scrapped one of its two daily money market operations from Aug. 6, and said it could use variable or fixed rates in repo and reverse repo auctions and conduct longer-term operations.
The central bank has been intervening to cap the rupee’s gains, buying dollars in a policy that has generated excess cash in the money market.
As a result, overnight call money rates have hovered near zero for weeks, complicating monetary policy.
HSBC economist Robert Prior-Wandesforde said intervening to suppress the rupee while fighting inflation with firm interest rates was unsustainable, and he saw another reserve requirement increase later in the year along with more rupee gains.
“If inflows continue the way they have been, we will be witnessing a similar situation a couple of months later,” he said.
The central bank said although headline inflation, which has eased below its 5% comfort ceiling, had slowed, upward pressures persisted, with risks from high and volatile crude prices, demand-supply gaps and firm food prices.
It warned banks and financial institutions to be prepared for higher volatility than before in financial markets worldwide.
But it said domestic economic activity continued strong and the base appeared to be broadening, and it retained its 8.5% growth forecast for 2007-08.