India's Central Bank Remains On Guard Vs Inflation

The Reserve Bank of India is likely to keep a tight rein on monetary policy for the rest of the year, even as Indian's economy comes off its gallop, due to concerns about latent inflationary pressures.

It's not a popular stance. A string of rate hikes are starting to crimp spending on cars and other consumer durables, leading industry bodies and prominent bankers to clamor for the RBI to reverse course and cut rates for the first time in four years. The U.S. Federal Reserve's rate cut last week led to calls for the RBI to follow suit. But the RBI is more worried about lingering inflationary pressures, even if turbulence in global financial markets that erupted in late July had seemed to enhance the downside risks to India's economy. Loan growth has slowed somewhat recently but analysts say it is likely to pick up again during October-March period as Indians increase spending on consumer durables during the festival and harvest season. Meanwhile, money supply growth remains strong, posing potential inflationary dangers. That means RBI Governor Yaga Venugopal Reddy will likely remain vigilant against inflation, analysts say. "Two quarters back the RBI was talking about overheating in the economy. It will not make a drastic change in its stance with an interest cut now. We need stability in interest rates," said Samiran Chakraborty, chief economist at ICICI Bank, the country's second largest lender. Chakraborty said he expects the RBI to keep rates on hold for the next six to nine months.

Economy Slowing, But Growth Still Fast

India's economy is showing signs of slowing down. But it's hardly a hard landing. Inflation, measured by wholesale prices, is at a five-year low of 3.32%, well below the RBI's comfort level of around 5% for the current financial year. On-year loan growth eased to around 23% in the four months to Aug. 31 from about a 30% average over the last four years. Industrial output grew 7.1% on year in July, the slowest pace since October 2006, and a much slower than growth of 9.7% in June. Most analysts expect India's economy to continue to grow between 8.5%-9% this fiscal year, easing slightly from an expansion of 9.4% last fiscal year that ended March 31. The weaker data reflect the central bank's steady efforts to cool the economy. Since January 2006, the RBI has raised its key lending rate, the repo rate, six times by a total of 150 basis points to 7.75% and its key borrowing rate, the reverse repo rate, three times by a total of 75 basis points to 6%. It has also hiked thrice this year the amount of cash that banks must set aside with the central bank. The cash reserve ratio now stands at 7%. Some Indian business leaders say the RBI has gone too far. India's main industry lobby, Confederation of Indian Industry, recently said that high interest rates are a cause for concern. A poll it conducted showed that 69% of chief executive officers it surveyed said the benchmark lending rates of banks should be lowered to about 12% from the current level of 13.25%. But the RBI's focus remains on inflationary risks. For one, the recent dip in inflation may be temporary. A large reason for recent benign inflation readings is a favorable base effect compared with elevated readings a year earlier. Meanwhile, crude oil prices continue to scale new highs, adding to India's import bill. The country imports two-thirds of its oil requirements. Lofty food prices are also creating inflationary pressure, said Ruth Stroppiana, director of Asia Pacific Economics at Moody's Economy.com. What's more, the money supply grew at a rate of 20% on year in the four months to Aug. 31, above the 17%-17.5% that the central targeted in its annual monetary policy review in April. In a recent speech, Reddy said: "It is, however, necessary to continuously assess the risks to the inflation outlook emanating from high and volatile international crude prices, the continuing firmness in key food prices and uncertainties surrounding the evolution of demand-supply gaps globally, as well as in India."

Capital Inflows Add To RBI's Woes

At the same time, the RBI isn't plagued by serious issues confronting the U.S. Fed: a steep housing downturn and associated problems in the market for risky mortgages and financial products based on them. Indian banks have little significant exposure to instruments like collateralized debt obligations, or CDOs, one type of instrument that has suffered from the U.S. subprime meltdown, analysts say. But the Fed's efforts to head off an economic downturn have compounded the inflationary challenges facing the RBI. The Fed's 50 basis point rate cut has spurred more capital inflows into India as investors seek India's higher yielding assets like the rupee and high-flying stocks. That's added to inflationary pressure in India. Barely two days after the Fed rate cut, the rupee hit its highest level in nine years, breaking past the 40 mark for the first time since May 1998. At 0605 GMT, the dollar was trading at INR39.82. Local stocks soared past the 16,000 mark for the first time fueled by foreign fund inflows which currently stand at over $10 billion to date in 2007. Some analysts say the RBI might raise its cash reserve ratio even more in a bid to temper the inflows. "If inflows remain strong and the appreciation of the rupee continues, the RBI may have to look at a cash reserve ratio hike," said Sujan Hazra, chief economist at Anand Rathi Securities.