India raises interest rates more than expected

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Published: July 27,2010

Tags: economy, inflation

MUMBAI, India — India’s central bank hiked key interest rates more than expected today to combat rising prices and raised its growth and inflation forecasts for the year.

The Reserve Bank of India hiked the repo rate — at which the central bank makes short-term loans to commercial banks — by a quarter percentage point to 5.75 percent. It raised the reverse repo rate — the rate at which it borrows from commercial banks — by an unexpected half percentage point to 4.5 percent.

Economists had expected quarter point hikes in both rates. The bank left the cash reserve ratio unchanged at 6.0 percent, as expected.

“The dominant concern that has shaped the monetary policy stance in this review is high inflation,” Gov. D. Subbarao said in his policy statement. “With growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation.”

Central banks across Asia are raising rates as they unwind post-crisis stimulus measures. South Korea, Malaysia, Taiwan and Thailand all raised policy rates in the last two months. But India faces the added pressure of inflation, which has been far higher than in neighboring countries since 2008.

Headline inflation, which hit 10.6 percent in June — a number that may well be revised upward — has been in the double digits since February. High prices have become a political issue, with opposition parties staging protests, and policymakers keen to check rising prices.

Last year’s drought pushed food prices up precipitously. This year the monsoon rains, which crash across India from June to September, are 14 percent below normal. Government meteorologists are predicting that overall rains will be normal, and the central bank said crop area has increased from last year, promising bigger harvests and lower food prices.

The bank raised its forecast for economic growth for the year through March 2011 to 8.5 percent from 8 percent thanks to better than expected industrial production and despite resurgent concerns about the health of the global economy. It raised its inflation forecast for March 2011 from 5.5 percent to 6.0 percent.

The bank said it is concerned that a faltering global economy could crimp trade, hitting India’s manufacturing and service sectors. A bigger worry, however, is that growing risk aversion would keep foreign investors out of India, slowing capital inflows needed to fund the nation’s widening current account deficit and meet credit demand.

The bank has hiked policy rates by three quarters of a percentage point this year, but still has a way to go before getting back to pre-crisis levels.

Rajan Bharti Mittal, president of business lobby group FICCI, said the hikes came as a “big surprise” and run the risk of slowing industrial growth.

There is an “underlying fear” that the rate hike will eventually lead to higher lending rates at commercial banks, he said in a statement.

A recent FICCI survey showed that 40 percent of business owners feel high borrowing costs are an impediment to performance.

Bank of America managing director Jayesh Mehta said the Reserve Bank did a good job balancing inflation and growth as India faces an uncertain global economy.

Like many others, Mehta expects the bank to hike rates by another quarter point in September, calling it a “done deal.”

“But we have to see how global things pan out, how commodity prices move and how inflation gets affected,” he said. “Inflation is a worry but if global commodity prices come off — people are talking about a double dip — I don’t think we’re going to be insulated.”

Meanwhile, there is only so much monetary policy can do to tame spiraling prices, which have been driven by rains, global commodities markets and supply side constraints.

“There’s a lot of supply side problems and huge demand growth,” said Shishir Bajpai, a senior vice president in private wealth management at Mumbai’s IIFL Capital. “Just increasing the rate — as RBI also knows— won’t itself curtail inflation. But it has to do what it can.”

The bank said the government’s recent decision to partially deregulate oil and gas prices will add one percentage point to headline inflation. Higher minimum payments to farmers will further fuel price rises.

The bank also said that given the rapidly evolving economic situation, it would conduct policy reviews every six weeks, instead of every quarter.

Investors took the news in stride. The benchmark Sensex index rose as much as 0.7 percent after the bank’s announcement, before settling to close up 0.3 percent at 18,077.61 points.

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