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Shock To The System

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On 26 July, the Reserve Bank of India (RBI) sent out a clear message. There will be no balance between growth and inflation in determining monetary policy: if growth has to be sacrificed to tame inflation, so be it. In its quarterly review of the policy for 2011-12 (FY12), the RBI hiked its policy rate by half a percentage point (50 basis points, or bps), surprising financial markets — which had expected a 25 bps hike — with its aggression.

Corporate India had hoped that the central bank's policy review would keep the growth imperative in formulating its policy measures; it was disappointed. So were the banks, whose credit growth is decelerating, impacting margins and profitability. But the cost implications passed through quickly enough.

The tone of the policy announcement was hawkish, and that's putting it mildly; the RBI revised its inflation rate forecast for March 2012 to 7 per cent, reduced its target for money supply and credit growth to 15 per cent and
18 per cent respectively. But in a report, Motilal Oswal Securities' analysts said this would not necessarily anchor inflation expectations.

Simply put, inflation is expected to stay high, even rise further, in the rest of the financial year. "Inflation is likely to accelerate further in the next two months, given that the impact of energy prices is yet to flow through," says Sajjid Chinoy, India economist at JPMorgan.

Up, Up And Away
A clutch of banks — Yes Bank, ING Vysya Bank and Development Credit Bank — all raised their base rates almost as soon as the policy was made public. Others such as Corporation Bank, Union Bank of India and other large banks are likely to follow suit. Deposit rates will also go up; banks need deposits to fuel credit growth.

What will this do to the corporate sector? "Apart from hitting the bottom lines in the form of higher interest cost for corporates (that have a leveraged balance sheet), the rate hike will force them to deleverage and rethink their capacity expansions," says Sanjiv Bajaj, managing director of Bajaj Capital. Stock prices of several interest-rate sensitive companies were impacted almost immediately, as the markets reacted adversely to the RBI's aggression.

But others have a different take. "I don't believe that funding costs are currently the binding constraint for corporate investment," says Chinoy. "Real interest rates are barely in positive territory and low by historical standards. The deterrent to private investment is both macro-economic instability, and regulatory and governance issues."

The day after the policy announcement, Union finance minister Pranab Mukherjee indicated that he understood the RBI's rationale for raising interest rates, perhaps even agreed with it. On the government's part, he appeared to say, his ministry would do what it could to support the war on inflation.

Overall economic growth has been taking hits for the past year or so; in the last quarter of FY11 (January-March 2001), GDP grew at just 7.8 per cent. The trend has been downward from April-June 2010 (9.3 per cent), through July-September 2010 (8.9 per cent and October-December 2010 (8.3 per cent).

Many economists have downgraded growth prospects for FY12 to 7.5 per cent. "We think it will be 7.5-8 per cent," says Suyash Choudhary, head of fixed income at IDFC Mutual Fund. Others say that's assuming a normal monsoon, with reasonable geographical distribution. So far the monsoon hasn't been spectacular.

Not The End Of The Road
Non-banking finance companies (NBFCs) that rely on banks will also be impacted. Without access to cheap deposits, their borrowing costs will spiral. Small and medium enterprises (SMEs) that rely on them will be similarly affected; add the increase in commodity and fuel prices, and the picture looks even bleaker.

What worries a lot of people is that the impact of the last few policy rate hikes haven't yet been fully transmitted through the system. So this latest greater-than-anticipated hike is expected to have an even deeper effect when it plays out through the economy. Many analysts expect a fuel price hike soon, compounding the effects even further.

"Even the latest hike may not be enough," says V.R. Srinivasan, CEO and director of Brics Securities, a Mumbai-based securities firm. "The medicine is not working. People aren't consuming any less or saving more, so the demand-supply gap will remain. Of course, there are side effects, like consumption declines in auto and other sectors, but demand is still strong."

Given how bad the news looks, will the RBI take a breather in the next policy review six weeks from now? Not likely, if one goes by the tone of RBI governor Duvvuri Subbarao's policy statement: "Going forward, monetary policy stance will depend on evolving inflation trajectory, which in turn, will be determined by trends in domestic growth and global commodity prices. A change in stance will be motivated by signs of a sustainable downturn in inflation".

In some quarters, the pessimism is darker than most. Here's what one brokerage house report said: "Growth, inflation and policy dynamics in this fiscal (FY12) look closer to the situation in the mid-1990s when high inflation and high policy rates co-existed with somewhat moderate growth."

Come September, we'll know a little more. But this much is certain: no analyst should take a chance on forecasting the end of the interest rate hike cycle again. Second-guessing the RBI is an uncertain business, and if you bet money on it, that's a losing proposition.


(This story was published in Businessworld Issue Dated 08-08-2011)