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Will he, won't he!

Oct 18, 2005

"There have been three great inventions since the beginning of time: fire, the wheel, and central banking," quoted Will Rogers. Probably, no other quotation would exemplify the importance of central banking more than what has been said above. Especially in these times, when global economies and their financial systems look more integrated than ever before, there has been a constant pressure on central banks worldwide to adjust their policies to global developments. And this has promoted the chiefs of central banks worldwide to the position of demigods' for the economy whose policies could have a lasting impact on growth and development.Similar has been the story for the Indian central bank, the Reserve Bank of India (RBI) and its Governors off late. Over the years, especially over the past decade, the RBI has taken policy measures that have helped the cause of the Indian economy in its initiatives of becoming more liberalized and more attuned to changes in the global environment.

And now, as the time for announcement of the mid-year review of the monetary policy for 2005-06 nears (October 25), all heads are turning to see what Dr. Reddy will do to interest rates, especially the headline reverse repo rate (a proxy of the US Fed funds' rate). As a matter of fact, the RBI had raised the reverse repo rate by 25 basis points to 5% in the last review of the monetary policy. Well, here are some of the factors that are favourable/unfavourable for a rate hike this time around.

Factors in favour of interest rate hike:

  1. RBI needs to follow global (read, the US) cues. Especially when the US Federal Reserve is hinting at continuing with its 'measured' pace of rise in interest rates, how can the Indian central bank take rest? This is because if the gap between the US and Indian rates narrows, Indian markets might witness a capital flight.

  2. The sharp depreciation of the rupee in wake of increasing current account deficit.

  3. As per economic theory, if a country's GDP growth rate is higher than the benchmark interest rate for a longer period of time, it might result into an overheating situation. Real GDP growth rate of over 6% and real interest rates at near 3% thus warrant a rate rise.

Factors not favouring an interest rate hike:

  1. While a rise in interest rates will perk up Indian banks' net interest margins, as the yield on advances will improve, considering that the banks would have to adjust the rate hike on their marked to market investment portfolio, profitability might be impacted.

  2. The US$ 300 m of portfolio outflows (equity and debt) that the country has witnessed in this month are miniscule and do not call for caution on the interest rate front.

  3. More importantly, any rise in cost of funds might dampen the spirit of India Inc that has been borrowing aggressively to fund capex plans.

Well, whatever be the central bank's decision this time, it would be indeed a tough one. Tough because if the bank decides to raise interest rates now when the Indian economy is looking like stepping on a higher growth trajectory, it might act as a dampener to prospects. On the other hand, if the bank does not raise the rates, it would be in a tight spot over inflation that has been rising, one major reason being sustenance of high crude oil prices.

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