Reserve Bank of India governor Raghuram Rajan has maintained a hawkish stance as he hiked interest rate to 7.75 percent while announcing his second monetary policy review on Tuesday.

The rate hike, second in two months, comes as the economy’s inflation woes refuse to die down and is likely to make loans dearer.

Rajan’s latest move has also proven to be a dampener for India Inc. “The RBI could have refrained from effecting a hike in repo rate, as industry is already reeling under pressures of high cost of capital and low availability in a tight liquidity situation,” industry body CII’s director-general Chandrajit Banerjee said.
While going in for a repo rate (rate at which RBI lends to banks) hike by 25 basis points – from 7.5 percent to 7.75 percent – the RBI has reduced the marginal standing facility (MSF) rate from 9 percent to 8.75 percent.

Repo rate has a direct impact on the cost of credit for consumers; MSF is a window through which banks can borrow funds overnight from the RBI against government securities. Thus, a decline in the MSF rate would make funds easily available to banks, which they can use to extend further loans.

Attributing the rate hike to the persistent inflationary pressures in the economy, Rajan said, “Both wholesale and consumer price inflation are likely to remain elevated in the months ahead, warranting an appropriate policy response.”

As inflation for the month of September shot up to a seven-month high of 6.46 percent despite RBI’s interest rate hike, the consecutive rate hike was the most likely option for Rajan.

“It is important to break the spiral of rising price pressures in order to curb the erosion of financial saving and strengthen the foundations of growth,” Rajan said. “It is in this context that the repo rate has been increased by 25 basis points.  Curbing mounting inflationary pressures and managing inflation expectations will help strengthen the environment for growth by fostering macroeconomic and financial stability.”

Earlier this month, the RBI had reduced MSF to 9 percent. A further reduction – to 8.75 percent – was in line with the measures to ease the stringent liquidity measures which the apex bank had announced in August to check the rupee’s free fall and increased outflow of capital, Rajan said.

“We began a calibrated change in the exceptional liquidity measures since September,” he said. “As steps to contain the current account deficit started taking effect in an improving external environment, and as volatility in the foreign exchange market ebbed, it became possible for us to unwind the exceptional liquidity tightening measures,” Rajan said.

Development work of RBI

In addition to changing the interest rates, the RBI governor also announced a slew of development measures the apex bank is working on. The list includes strengthening the monetary policy framework, enhancing the country’s banking structure by allowing entry of new banks, branch expansion, and facilitating entry of foreign banks, deepening the country’s financial markets, ensuring easy availability of funds to the MSME sector and focusing on restructuring and debt recovery processes.

“Action on the monetary policy framework will follow the submission of the Dr Urjit Patel committee report. A number of measures to strengthen bank structures and financial markets have already been announced, and more will follow as they are worked out. The strategy to expand financial inclusion will be informed by the Dr Nachiket Mor committee report, though significant efforts to explore the use of technology are already under way,” Rajan explained.
Regarding his announcement in Washington to ease entry of foreign banks, and assuring them near national treatment, Rajan said details of the scheme will be released on the RBI website “within two weeks”.

From the day he took over as the governor of RBI in September, Rajan has made it clear that keeping a check on inflation was the primary role of the RBI, which needs to be balanced with the growth objective.

Getting the flak

Prasenjit Bose, political activist and Left economist, said the premise on which the RBI had based its interest rate policy is wrong. “I had expected the move but it is important for our institutions to understand that in India there is cost-push inflation which arises due to supply-side constraints. Hence, raising interest rates does not make sense,” Bose said, pointing at the continued existence of inflationary pressures despite several rate hikes.

While Rajan’s latest move comes in line with analysts’ expectations, it has poured cold water on the hopes of India Inc, which had requested for a relaxation in interest rates to boost investor sentiment.

“The commensurate rise in repo rate has come as a disappointment to industry, especially as the investment climate continues to be weak and growth outlook remains muted as a high interest rate regime deters consumption and investment demand,” CII chief Chandrajit Banerjee said.

Banerjee said that inflation in the country was a supply-side led issue and therefore, “raising interest rate would hurt growth while proving unequal to the task of tackling inflation.” Pointing out that inflationary pressures would calm down as food prices would see a decline soon, the RBI should have instead looked at providing an impetus to growth, he said.