India: RBI Applies Shock Therapy

 Econintersect by Sanjeev Kulkarni:  In a surpise move RBI (Reserve Bank of India) has hiked a key interest rate by 50 basis points.  A hike of 25 basis points had been expected by many and some had even argued that not hike was needed at this time.  Sunil Chandra (GEI Analysis) last weekend observed that the bond market was showing behavior that was consistent with a fear of a 50 bp or higher rate hike.  After ten previous 25 bp rate increases over the past twelve months, the most recent action has boosted the overnight interest rates in India to 7.25% (repo) and 6.25% (reverse repo).  The CRR (cash reserve ratio) was held unchanged at 6%.

The RBI lowered its estimate for real GDP growth in 2011 to 8%.  The response from the stock market was quick and decisive.  The Bombay Sensex dropped 2.5% (463 points) to close at 18,534.  Many markets across the Far East also fell, with only Shanghai (+0.7%) and Tokyo (+1.6%) showing advances.

The Bombay Sensex is now down 5.9% from its recent closing high of 19,697 on April 13.

Oil prices also fell reflecting an expectation for reduced demand.  Bloomberg is reporting oil prices down from 1% to 1.4% in New York and London for spot prices and futures contracts.

The significance of the rate hike was discussed by Robert Prior-Wandesforde, Head of India & South East Asia Economics of Credit Suisse on CNBC:

First of all, this meeting marks a change with the Reserve Bank of India (RBI) finally getting serious about inflation. A key question here is why the seriousness in tackling inflation came in so late. In September-October last year, it seemed crystal clear that inflationary pressures were intense, at that point underlying inflationary expectations and better measures of inflation than just the wholesale price index (WPI), why were they hinting at pores.

It suggests that they will lag behind, somewhat. Meanwhile, other interesting thing is that they are now prepared to accept some short-term negative growth consequences from this move and indeed it’s on cards. Growth is likely to surprise on the downside. We are at the bottom end of the range at 7.5% for growth. Considering the 50 basis points (BPS) hike, we may get at least another 50 basis points beyond this. The real test for the Central Bank will be to continue rate hikes when the economic profit (EP) growth starts with 7% and can the politicians, the RBI continue to endorse it. We are going to look at the lower end of their range.

Sources:  The Economic Times, Business Standard, Bloomberg Energy, CNBC and GEI Analysis

Sanjeev Kulkarni is an entrepreneur based in Pune, India. He worked for large organizations in board level position before venturing on his own. He is currently involved as an investor in health care software company and as an investor, mentor in an automation company. Very widely traveled, he has experience of working in different geographical areas with people of varying nationalities. He did his BS from Indian Institute of Technology, Delhi.