Market celebrates RBI interest rate hike – why?

RBI increased the repo rate (at which it provides short-duration loans to banks) and the reverse repo rate (at which banks maintain short-duration deposits with the RBI) by 25 basis points each. The repo rate is now 8.5% and the reverse repo rate is now 7.5%. The CRR has been left unchanged at 6%.

With inflation remaining stubbornly high despite 12 rounds of rate increases since Mar 2010, it was widely expected that the RBI will increase the repo and reverse repo rates by 25 bps (0.25%) today. The market should have already discounted the rate hike. Why the buying celebration then? Was there some good news that the market liked?

Apparently, there were three. First, and most important, the RBI governor hinted at inflation rate moderating to 7% by Dec ‘11, in which case there will be no further rate hike at the end of the year. Moderation of inflation and a likely pause in the rate hike cycle was considered ‘good news’ by the market.

Also, for the first time ever, interest rate on savings bank accounts have been de-regulated. That means banks have the freedom to offer any interest rate on savings bank accounts that they deem fit. Last, but not the least, banks have been given the freedom to open branches in Tier-II through Tier-VI towns without prior permission.

Let us look a little more critically at each of these pieces of ‘good news’.

How will inflation suddenly moderate to 7% in less than 2 months when it has remained uncontrollably high for the past 20 months? Will food prices suddenly fall? Will government employees get less salary? Will politicians become honest and stop their looting? The answer is: none of the above.

The moderation will happen due to the ‘base effect’. Inflation was already high in Dec ‘10. So the YoY increase in Dec ‘11 will appear to be less. Actual prices that we pay will remain almost the same as now. There is also a possibility that diesel and kerosene prices will finally be increased if inflation does moderate. So, we may get back to square one.

What about the pause in the rate hike? Well, that won’t help much either. Better than bad isn’t necessarily good. As per RBI’s guidance, the GDP growth rate has been revised down from 8% to 7.6% in year ending Mar 2012. There are already signs of growth slowdown, which will be exacerbated by today’s rate hike. Unless interest rates start heading downwards, stock markets are unlikely to go up.

Is the saving bank interest rate de-regulation good news? Certainly not for banks. Their business has already been hampered by high interest rates – due to which loans have become dearer and term deposit rates have gone up. If interest rate on savings bank accounts is increased, it will be a direct hit on bank bottom lines.

As per the Economic Times, if savings bank interest rate is increased from the current 4% to 5%, then all the banks put together may need to pay out an additional interest of Rs 15,000 Crores, which may reduce the entire banking sector’s profitability by 13%.

Look at it another way. Savings bank account holders will collectively receive an extra Rs 15,000 Crores. What will they do with the sudden inflow? Why, spend most of it. Will that stoke the fires of inflation or not? You tell me!

SBI has the largest percentage of savings bank accounts among all banks (Yes Bank has the fewest) and will be affected the most by an increase in savings bank interest rate. The CMD went on record that SBI will not increase the savings bank interest rate. He also said that de-regulation means rates can also be reduced.

What about opening branches in small towns? It may help in financial inclusion of people living in remote areas where no bank branches exist. But if there was a lot of business potential in Tier-II through Tier-VI towns, banks would have sought permission to open branches there by now. By removing the red-tape of prior permission, the business potential of remote corners of the country is not going to increase overnight. But opening branches will add to the operating costs of banks.

The ‘good news’ doesn’t seem so good, does it? What was the reason for the buying today? It was a combination of short-covering and index management – today being early F&O ‘expiry day’ because of the Diwali holiday. The broader markets didn’t participate much in the rally.

Both the Nifty and the Sensex are poised at the upper end of their respective trading ranges of the past 11 weeks – with the huge gaps caused in Aug ‘11 remaining unfilled. Tread with caution.