RBI narrows rate corridor with repo, reverse repo hikes

Reserve Bank of India lifts repo and reverse repo rates in first-ever mid-period policy review; narrows rate corridor as flagged to cut market volatility

The Reserve Bank of India (RBI) on Thursday used its first mid-quarter policy review to levy hikes to the repurchase and reverse repurchase rates, citing "unacceptably high" levels of inflation.

The central bank raised its repurchase rate by 25 basis points, taking it to 6%, and its reverse repurchase rate by 50 basis points, taking it to 5%.

Provisional figures, published Tuesday by the government, showed wholesale price inflation had come down to 8.51% in August, from 9.78% in July. While inflation appears to have plateaued, it remained significantly higher than the decade's trend levels of between 5% and 5.5%, the central bank noted. "There is, therefore, need for continued policy response to contain inflation and anchor inflationary expectations," the RBI said.

Commentators said markets had been expecting the RBI to tighten. Mumbai's benchmark Sensex 30 stock index shed 0.43% by the close of trade. Financial stocks, however, outperformed all other categories, gaining 0.75%.

Rahul Bajoria, a Singapore-based analyst for Barclays Capital, an investment bank, told CentralBanking.com that most investors had priced in the 25 basis point repo rate hike, but that the 50 basis point increase to the reverse repo rate was larger than expected. "The reverse repo hike seems a bit hawkish on face value, but it follows on from the RBI's objective of reducing the volatility in the liquidity adjustment facility corridor," Bajoria said.

Tightened rate corridor
The decision narrows the corridor between the repo and reverse repo rates, which together constitute the RBI's liquidity adjustment facility, to 100 basis points, down from 125. The central bank had hinted at this move. The repo rate dictates what banks pay to borrow from the RBI. The reverse repo rate determines what the central bank pays to lenders on the deposits they park there.

Lenders are now facing a liquidity shortfall, driven by increased demand for credit and a fall in the growth rate of deposits, sparked by the impact of high inflation, through the negative real interest rate channel. "If bank credit is not to become a constraint to growth, real rates need to move in the direction of encouraging bank deposits," the RBI said. Bajoria noted that although the central bank had started hiking rates in March, the impact on commercial banks' loan and deposit rates had been slow. "By narrowing the corridor, the RBI has signalled that it wants real interest rates to be within that smaller 5% to 6% point zone- so banks will lend at a minimum of 5% and borrow at a maximum of 6%. This helps reduce uncertainty for them," he said.

Mid-period reviews
Banks felt reassured as a result of the mid-period review, Rajiv Sahoo, a Bangalore-based economist at Canara Bank, one of the country's four largest, told CentralBanking.com. "The mid-period review is not new in itself, but publishing it is helpful," he said, adding that it had it helped markets anticipate the rate moves. The central bank said in late July that it would start issuing the mid-period reviews, effectively doubling the number of published reviews per annum, taking the total to eight.



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