RBI raises interest rates again but inflation remains untamed. What next?

The RBI raised both the repo rate and reverse repo rate by 25 basis points. The repo rate (i.e. the rate of interest at which RBI loans money temporarily to banks) is now 6.25% and the reverse repo rate (i.e. the interest rate which RBI pays to banks for temporary deposits) is now 5.25%.

No real surprises there. The market was expecting a 25 basis point hike. The CRR rate has been untouched and remains at 6%. What is the purpose of these periodic interest rate hikes? It is an attempt to stifle the liquidity in the market. In other words, make the cost of borrowing a little less attractive.

Why would RBI want to stifle liquidity in the market just when things are going great? Tax collections are improving. So is industrial production. Cars are selling like hot cakes. The stock market is at a peak. My staid uncle and aunt – who never ventured beyond Puri or Darjeeling for their annual holidays – visited Sri Lanka! Why try to fix some thing that hasn’t broken yet?

To give the devil its due, the RBI is being proactive by erring on the side of caution. One of the main reasons that the Indian economy didn’t collapse during the recent global recession was the stringent steps and controls put in place by the RBI and Finance Ministry. There was a real estate bubble – particularly in Mumbai and the Delhi region – but the banks managed to come out of the fiasco reasonably unscathed.

India’s huge fiscal deficit, plus a continuous flow of FII funds (some of which have a very questionable dark colour and are being re-routed from a picturesque country in the Alps) can lead to rising inflation. By acting before things begin to go out of control, the RBI has shown commendable financial acumen.

Are these frequent rate hikes (the sixth since Mar ‘10) having the desired effect? The jury is still out. Inflation has been contained at best but doesn’t show any tendency of going south. Specially food inflation. In spite of a good monsoon, vegetable and fruit prices remain high.

The RBI has to walk a fine line between reducing inflation and ensuring that economic growth doesn’t get affected. If interest rates are hiked by a larger amount, companies may hold back on their borrowings and curtail their expansion plans. If rates are left untouched, inflation may increase.

What could be done, and isn’t being pursued vigorously by the Indian government, is to find a methodology to channel the flow of overseas funds into productive uses rather than being used in ‘benaami’ transactions in real estate and the stock market. That would solve many problems in one go, considering the stupendous amounts stashed away overseas by our venerable “people’s representatives”.

Wishful thinking, I suppose. What next for investors? The US Fed is likely to announce the next round of ‘Quantitative Easing’ later in the week. That means more inflows into the emerging markets. It won’t be surprising to see the Sensex reach a new all-time high before we say good-bye to 2010.

With not much left in its armoury, the RBI may continue to raise interest rates in baby steps. At some point, investors will opt for risk-free bank fixed deposits by cashing out some of their riskier equity holdings. Year-end profit considerations may lead to some FII selling. Any dips in the Sensex should be used to buy fundamentally strong stocks that are trading well below their 52 week highs. (Such stocks are difficult to find with the Sensex above 20000 – but not impossible.)

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