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RBI minces no words

Apr 21, 2008

After saying 'No' to demands of an interest rate cut in its third quarter review of the monetary policy for 2007-08, the Reserve Bank of India (RBI) has once again displayed signs of its independent thought process and actions. Late last Friday, the Indian central bank, unlike its international peers (like the US Federal Reserve and Bank of England) raised the Cash Reserve Ratio (CRR) by 0.5% to 8%. This increase in CRR is effective in two tranches, with the first 0.25% hike effective April 26, 2008 and the second May 10, 2008. By definition, CRR is the amount of funds that banks have to keep with the RBI. If the RBI decides to increase this rate, the available amount (to lend) with the banks comes down. The RBI is using this method (increase in CRR), to drain out the excessive money from the banking system. As reported on the central bank's website, this hike is expected to draw out Rs 185 bn from the banking system. Thus, with lower funds available with banks to disburse, there is a general feeling that interest rates might head upwards again or, at best, remain at the current levels rather than coming down.

In hiking the CRR, the RBI has reiterated its fight against inflation, which (as calculated on Wholesale Price Index) crossed the 7% level during late March this year. For the week ended April 5, 2008, this rate stood at 7.14%, which is significantly above the RBI's targeted band of 5% to 5.5%. As indicated above, this move from the RBI comes at a time when central banks worldwide have been lowering interest rates to ward-off the financial contagion created by the US housing sector meltdown and the ensuing subprime mortgage crisis. In lowering rates, these central banks have given less regard to the rising inflation in their economies for reasons like higher prices of food and fuel. The RBI's stance, thus, places it in a select category of central bankers (and these are very few) that have been independent and unbiased in their policy actions of maintaining price stability.

What effect this move from the RBI will have on the broader stockmarkets cannot and should not be predicted. Banking stocks, though, might display some knee-jerk reaction, as CRR in a way penalises the banks by requiring them to keep higher reserves with the central bank almost free of cost. We have though not heard any banker raising voice about a subsequent hike in interest rate on loans. The RBI is slated to hold its annual policy meeting on April 29 (next Tuesday). Its next round of inflation targeting policies will be announced therein.

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