RBI spreads cheer by Sparing Interest Rates

RBI Spares Interest Rates Implications and Opportunities

Opens capital outflow tap to manage liquidity.

After five increases in the past year, the Reserve Bank of India (RBI) today kept the key signalling rates unchanged in its annual policy statement for 2007-08.

The central bank chose to encourage more foreign exchange outflows and stem the threat of inflows in its fight against inflation.

The RBI set a challenging inflation target of 5 per cent for the current year, indicating that continuing breach of this new target would attract further monetary tightening.

Having increased the amount of cash banks need to keep with it (the cash reserve ratio) by 150 basis points to 6.75 per cent of deposits and the repo rate by 50 basis points to 7.75 per cent since December 2006, the RBI decided to put on hold any further tightening for now.

The RBI indicated its intolerance for excessive liquidity and its impact on inflation by announcing a measure outside the policy. It increased the ceiling on absorbing liquidity through bond auctions under its market stabilisation scheme (MSS) by Rs 15,000 crore to Rs 95,000 crore.

This caused government bond prices to lose part of the gains made earlier in the day. The yield on the 10-year benchmark bond closed at 8.02 per cent after touching a low of 7.96 per cent and against yesterday’s close of 8.10 per cent.

The central bank has taken two broad measures to check the net foreign exchange inflows.

First, it has tried to discourage foreign currency inflows by making deposits by non-resident Indians (NRI) less attractive. Second, it has allowed greater outflows by companies and individuals.

To this end, the ceiling on interest rates banks can pay on NRI deposits has been reduced by 50 basis points.

The ceiling on overseas investments by companies has been raised to 300 per cent of their net worth from 200 per cent and by mutual funds to $4 billion from $3 billion.

The limit on pre-payment of overseas borrowings has been enhanced to $400 million every year from $300 million.

Ballooning inflows had led to the RBI buying foreign currency worth $11.86 billion in February 2007 alone, which was almost equal to the total purchases made in the 10 months ended January 2007.

The status quo on interest rates has come as a major relief to banks, over half of which were expecting further hikes in key rates in the annual policy announcement.

Another major positive for banks is the reduction in the risk weight for capital allocation on home loans of up to Rs 20 lakh to 50 per cent from 75 per cent.

At a minimum capital adequacy requirement of 9 per cent, banks will be required to provide Rs 4.50 per Rs 100 of loan now, against Rs 6.75 earlier.

The reduction followed with an advice to banks to pass on the benefit to customers. Initial industry estimates put the amount of capital that would be freed because of this at Rs 2,100 crore.

The enduring strength of foreign exchange inflows has complicated the conduct of monetary policy. An increase in interest rates increases the possibility of further capital inflows, apart from the associated costs for growth and potential risks to financial stability, RBI Governor Y V Reddy said.

The unchanged policy rates and enhanced room for investments overseas helped the sentiment in the equities market, which reflected in the Bombay Stock Exchange’s Sensex rising by 216 points.

Significantly, the central bank has forecast economic growth at around 8.5 per cent for 2007-08, lower than 8.5-9.0 per cent for 2006-07 and the government’s advance estimates of 9.2 per cent growth. This is an indication that the RBI wants the economy to soft land and not get overheated.

The central bank also reduced its medium-term inflation goal to 4.0-4.5 per cent from 5 per cent. Inflation has been ruling above 6 per cent since December 2006, which prompted the RBI to take sharper monetary measures during the period.

Hedging norms have also been liberalised substantially. Domestic producers and users of aluminium, copper, lead, nickel and zinc have been allowed to hedge in overseas markets like the London Metal Exchange.

Airlines have also been permitted to hedge their aviation turbine fuel (ATF) requirements in overseas markets. For all other hedging requirements, the RBI will consider requests on a case-by-case basis.

Meanwhile in New Delhi, Finance Minister P Chidambaram praised the RBI for doing a balancing act to contain inflow.