RBI stays on hold, but unlikely for long, says Dalal Street

The Reserve Bank of India (RBI) on Thursday refrained from raising interest rates during its mid-quarterly review — as alluded to during the November review.

But the refrain on the Street is that it may not be long before the seventh rate hike since March comes about — in January — because inflation remains way beyond the RBI’s comfort zone of 5%, and the economy is showing signs of strong growth.

“Inflation is likely to trend higher due to consumer demand and rising commodity prices,” Sonal Varma, a Mumbai-based economist at Nomura Holdings Inc, said.

The RBI said though inflation has moderated, inflationary pressures persist both from domestic demand and higher global commodity prices.

“The pace of decline in food price inflation has been slower than expected. There is a risk that rising international commodity prices will spill over into domestic inflation. The risk to our projection of 5.5% inflation by March 2011 has still not been tackled with,” the central bank said.

RBI also unveiled two steps to ease liquidity in the banking system — a one percentage point cut in the statutory liquidity ratio (SLR) to 24% and an open-market operation to buy bonds worth Rs48,000 crore in a month.

Banks have to invest a portion (now 24%) of their total deposits in government securities.

“The RBI’s main concern at this point in time is to address the tight liquidity situation,” said Jay Shankar, chief economist at Religare Capital Markets Ltd in Mumbai.    

“It will most likely resume rate hikes in January as inflation pressures are growing stronger.”

India’s financial system has been squeezed by unusually tight liquidity conditions since November, with banks forced to borrow an average Rs 100,000 crores a day from the liquidity adjustment facility window of the RBI, crimping their ability to lend.

The announcement on bond buybacks gives investors confidence that the RBI intends to inject liquidity into the system even as the government continues with its bond issuance programme.

Trimming SLR gives banks more flexibility to borrow from  the RBI and fund short-term operations.

V R Iyer, executive director, Central Bank of India does not see any immediate impact of the SLR cut. “But in the long run, the 100 basis points would infuse some Rs 50,000 crores into the system. We expect credit growth to accelerate from mid-January, but by then government spending should flow back into the system,” Iyer said.

A Prasanna, economist and vice-president at ICICI Securities Primary Dealership said Thursday’s policy statement is clearly focused on liquidity.

“Although the RBI has expressed its concerns on inflation, its liquidity easing steps have diluted the anti-inflationary stance. Open market operations of Rs 48,000 crore in one month is equivalent to a cash reserve ratio cut of 100 basis points. I think the RBI will need to hike rates in January by 25 basis points,” Prasanna said.

Robert Prior-Wandesforde, an economist at Credit Suisse in Singapore, said the “very hawkish tone of the RBI statement has persuaded us that the next repo and reverse repo rate hike is most likely to come at the policy meeting on January 25”.

Prior-Wandesforde had previously expected the central bank to refrain from raising rates until March, and now expects 75 basis points of tightening by August.

Still, bond yields and swap rates tumbled after the RBI announced the liquidity-easing measures.

The yield on the 10-year benchmark 7.80% 2020 ended at 7.96%, down from 8.08%.

“The yield will move down further by 5-10 basis points in the near term,” said Siddhartha Sanyal, chief India economist at Barclays Capital.