RBI may retain interest rates, and may raise CRR

The Reserve Bank of India is likely to keep key interest rates unchanged in its quarterly review of credit policy on July 31, but may increase the requirement for banks to keep cash with it to absorb excess liquidity in the system, economists and industry players feel. "Inflation concerns have been mitigated and interest rates are at peak. However, the desire to mop up liquidity remains and a hike in cash reserve ratio cannot be ruled out," ABN Amro Country Executive (India) Romesh Sobti said.

After touching a 14-month low of 4.03 per cent, inflation has been on an upward trend on account of rising prices of food, especially vegetables. For the week ended June 30 and July 07, the wholesale price index stood at 4.27 per cent. Even at this level, the index is within RBI's limit of five per cent for this fiscal and medium term target of 4-4.5 per cent. On the other hand, there is ample liquidity in banking system. The overnight rate at which banks borrow from each other in the call money market has been below one per cent for sometime now. On July 13, the rate was 0.49 per cent. "I expect RBI to raise CRR in the policy review to manage liquidity," HDFC Bank chief economist Abheek Barua said.

Cash Reserve Ratio (CRR), the requirement for banks to keep a certain portion of their deposits with RBI, stands at 6.5 per cent. Between December 2006 and March 2007, the ratio was increased thrice by half a percentage point each, which sucked more than Rs 45,000 crore from the system. Barua said the advantage of a CRR hike was that it worked dynamically. While the initial impact is to absorb liquidity, it dampens the entire process of money creation that works through successive rounds of lending, he said.

Echoing similar views, Crisil Principal Economist D K Joshi said there was no need to change key lending rates, but a CRR hike was a possibility to rein in liquidity. Oriental Bank of Commerce executive director Allen C A Periera also said interest rates should be left unchanged for the time being.

Although economists and banking experts agreed that some action from the RBI to curb liquidity was due, they differed on the methodology it should adopt. Some experts said a CRR hike will be too much for the banking sector to take. Joshi also said instead of a CRR hike, the RBI might use another tool -- Monetary Stabilisation Scheme (MSS) -- more aggressively for liquidity management.

The RBI Governor, Y V Reddy, had recently said that taking into account high expansion of money supply worldwide, and given the monetary overhang of 2006-07, it was important to contain monetary expansion at around 17 per cent this fiscal, in consonance with the outlook on growth and inflation. High funds inflow, which is leading to excess liquidity, might see some moderation due to tightening of norms for external commercial borrowings by the government recently and pick up in credit offtake by August.

"In the given scenario there is no need for tinkering with the interest rate as well as CRR rate as inflation is low and credit demand has slowed down," Punjab National Bank executive director K Raghuraman said. MSS auction is a better option to manage liquidity since an increase in CRR could push up interest rates. This could lead to higher inflow of foreign funds as they would find Indian market more attractive. This would lead to further appreciation of Rupee, he said.

The Source: The Hindu - July 17, 2007