India's central bank laid the groundwork on Tuesday for a rise in interest rates by tightening credit to the commercial property sector, lifting its inflation forecast and warning of the threat of asset price bubbles. As expected, the Reserve Bank of India (RBI) left key interest rates on hold but surprised markets by removing emergency liquidity support measures that were implemented to protect Asia's third-largest economy from the global downturn.
Stocks extended losses to 2.5 percent after the quarterly policy review and property shares fell 7.3 percent as the RBI raised bank provisioning requirements for commercial real estate loans. "This could be one way for them to signal rate hikes are imminent. It is tightening of course," said Ramya Suryanarayanan, economist at DBS in Singapore.
Despite the tightening, government bond yields fell after the central bank raised the amount of deposits banks are required to keep in government securities, soothing worries about the market's ability to digest this year's record borrowing. The central bank, which has been under pressure from government officials to maintain its loose monetary policy, kept its growth forecast for the fiscal year ending in March 2010 at 6 percent with an upward bias.
India's economic growth slowed to 6.7 percent in the year through March after three years of growth at 9 percent or more. However, the central bank raised its fiscal year-end projection of wholesale price inflation to 6.5 percent from 5 percent, with an upward bias, reinforcing market expectations that the central bank will start raising rates early next year. Some economists see inflation hitting about 8 percent by March, much above the central bank's comfort zone seen at about 5 percent.
"It may be appropriate to sequence the exit in a calibrated way so that while the recovery process is not hampered, inflation expectations remain anchored," the central bank said in its quarterly review. It also said there was a "critical need" for the government to borrow less and help sustain moderate interest rate levels.
Effective immediately, the RBI ended a special repurchase facility for banks and another for the funding needs of non-bank financial companies, mutual funds and housing finance companies. It also ended a foreign exchange swap facility for banks, and cut an export credit refinance facility to a pre-crisis level of 15 percent from 50 percent with immediate effect.
The central bank also raised the statutory liquidity ratio (SLR) of commercial banks to 25 percent from 24 percent effective November 7, and said the collateralised borrowing and lending obligation liabilities of banks would be subject to cash reserve ratio requirements from November 21. Analysts said raising the liquidity ratio would make it easier for the government to borrow and the bond market welcomed the move with the benchmark 10-year government bond yield falling 21 basis points.
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