By Cherian Thomas and Manish Modi
July 30 (Bloomberg) -- India's central bank put the battle against inflation before economic growth in Governor Yaga Venugopal Reddy's final interest-rate decision, spurring speculation of further increases in borrowing costs.
The Reserve Bank of India yesterday raised its benchmark repurchase rate by half a percentage point to 9 percent, more than economists forecast. The rate will climb to between 9.25 percent and 9.5 percent in the next three months, according to eight of 12 economists surveyed by Bloomberg News after the announcement.
Reddy, 66, made inflation the central bank's ``overriding priority,'' according to a statement in Mumbai accompanying the increase, the strongest comments since he began a five-year term in 2003. Higher rates may not bring inflation down quickly enough from a 13-year-high for the government to appease disgruntled voters before elections due by May.
``More tightening is on the cards,'' said Maya Bhandari, a senior economist at Lombard Street Research Ltd. in London. ``Slowing down inflation will depend on what happens to oil, the currency, and if banks are allowed to pass on some of this tightening.''
Reddy, who has been raising borrowing costs since 2004, has had to contend with a government that uses Soviet-style price controls. That complicates monetary policy, because it makes the economy vulnerable to unpredictable price shocks -- as happened in June when the government was forced to cut fuel subsidies to protect refiners from going bankrupt after oil prices surged.
India's inflation rate subsequently jumped to 11.91 percent from 8.75 percent in five weeks as higher prices of gasoline and diesel fed into the economy, forcing Reddy to raise rates by 125 basis points.
Weaker Currency
Reddy also had to contend with a weakening rupee this year, which has pushed up the cost of imported goods. Forty percent of the commodities in India's benchmark wholesale-price index are sensitive to changes in the currency, Lombard Street's Bhandari said.
The estimated $42.5 billion in oil subsidies that the government keeps outside its accounts along with other pre- election handouts also pose ``severe challenges'' to monetary policy, the central bank said yesterday. The government, for instance, has waived $17 billion of farm debt.
There is a ``likelihood of the proceeds of the farm waiver coming into the system'' as well as government spending stoking demand, said Rohini Malkani, a Mumbai-based economist at Citigroup Inc. ``Inflation wins hands down over growth.''
Inflation can win or lose elections in India, where half the population of 1.1 billion people lives on less than $2 a day. Prime Minister Manmohan Singh's Congress party lost ground in nine of the 11 state polls since January 2007.
Chidambaram's Priority
Finance Minister Palaniappan Chidambaram has for a large part of the past four years placed economic growth as a priority. His ministry yesterday endorsed the central bank's actions.
To support the government's growth objectives, Chidambaram often directed the state-run banks that dominate India's financial industry not to raise their lending rates. That put them at odds with the central bank's policy.
``When Mr. Chidambaram talks about containing rates, Dr. Reddy speaks about inflation,'' State Bank of India Ltd. Chairman O. P. Bhatt said in a speech in 2006. ``As bankers we don't know which way to look.''
State Bank, the nation's biggest by assets, cut its benchmark prime lending rate twice in February after Chidambaram asked banks to revive slowing loan growth and increase investment in Asia's third-biggest economy.
Term Ending
Reddy's term expires in September with inflation still more than double the central bank's goal. His successor hasn't been named. Reddy is eligible for an extension along the lines of his predecessor Bimal Jalan, who held the job for an extra year.
India's economy was in danger of overheating when Reddy took office in September 2003. He began raising the two interest-rate tools at his disposal to damp inflation and contain rising property and stock prices.
While he was battling inflation as oil and commodity prices climbed over the next three years, he faced the problem of record capital inflows in 2007 that caused the currency to appreciate the most in more than three decades.
Reddy switched to using the cash reserve ratio as his main policy tool to tame inflation and manage the currency, to avoid higher rates from attracting more foreign capital.
``Reddy was right in raising rates then. He was right in resorting to cash reserve ratio subsequently,'' said Robert Prior-Wandesforde, senior Asian economist at HSBC Group Plc in Singapore. ``It's hard to fault him.''
Energy Role
As oil prices surged 50 percent this year to a record $147.27 a barrel, Reddy continued to raise the central bank's cash-reserve ratio while keeping interest rates on hold. Some investors say that wasn't enough to prevent inflation from getting out of control.
``The central bank was behind the curve'' this year, Krishnamoorthy Ramanathan, who manages $1.9 billion in Indian debt at ING Investment Management Pvt. in Mumbai, told Bloomberg News before yesterday's policy decision. ``The bank can't give the market a one-off shock of 1.5 percentage points and will have to keep raising rates by 25 or 50 basis points.''
India's Rate Forecasts
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Cash
Reverse Reserve
Company Repo Rate Repo Ratio
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Number of Estimates 12 11 12
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Axis Bank Ltd. 9.25% 6.00% 9.50%
CARE Ratings 9.25% 6.00% 9.25%
Edelweiss Securities 9.00% 6.00% 9.00%
Forecast Singapore 9.25% 6.00% 9.50%
Goldman Sachs 9.25% n/a 9.25%
HSBC Singapore 9.25% 6.00% 9.25%
Inst. of Economic Growth 9.00% 6.00% 9.00%
JPMorgan Chase Bank 9.50% 6.00% 9.25%
Kotak Mahindra Bank 9.00% 6.00% 9.00%
Lehman Brothers 9.00% 6.00% 9.25%
Lombard Street Research 9.25% 6.00% 9.25%
Standard Chartered Bank 9.50% 7.00% 9.75%
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Note: * Axis Bank expects 9.5%-10% level for CRR
by the next policy.
To contact the reporter on this story: Cherian Thomas in New Delhi at cthomas1@bloomberg.net
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