WHY AND WHAT NEXT?

Reasons for the tightening and likely impact
The RBI made its strongest monetary tightening move, yet, today. The repo-rate has been hiked by 25bps to 7.75% with immediate effect The CRR has been hiked by 50bps in two stages of 25bps each to 6.5%. The first hike will come into effect from April 14 and the next hike from April 28.
Both moves are aimed at tightening liquidity. A hike in the repo rate makes it difficult for banks to borrow from the RBI, indirectly impacting their ability to lend. A hike in the CRR likely aims at sucking out excess liquidity generated through RBI intervention in the foreign exchange market.
The move is not entirely surprising. The RBI was hawkish in February when it hiked CRR and we had pointed out to the possibility of further monetary tightening in FY07.

We believe that the timing of the move is explained by:
> Sharp recent appreciation in the rupee (to an intra day high of 43.03) and the rise in
foreign exchange reserves over the previous quarter (average rise has been USD 1.8
bn each week last quarter).
> Healthy balance of payments data released today shows that foreign exchange inflows
maybe resilient despite a weakening US economy. This suggests that going forward as
well; we may see continued appreciation in the rupee.
> The credit growth numbers, also released today, also suggest no let up till year end.Credit is still growing by 29%, as opposed to RBI comfort level of 25%. This keeps inflation concerns alive.

Going forward, we do not see further monetary tightening by the RBI in the April 24 policy meeting. If external flows continue to be robust, CRR will likely remain the preferred monetary instrument in FY08. Rate hikes are likely to reflect in a GDP growth of 8-8.5% in FY08 as opposed to 9% plus in FY07.

Why has the tightening happened?
The RBI press release points out to a number of reasons as to why further tightening has taken place: stronger than expected real growth, continued strong credit off take, high inflation, steep increase in foreign exchange reserves over the last one quarter and tightening across major global central banks (BoJ, PBoC and ECB).
There are however two pressing questions around the latest round of hikes:
> Was the tightening really unexpected?
> Why has the RBI chosen this time to hike rates?
The RBI sounded very hawkish in the previous press release after monetary tightening took place on February 13. We had pointed out to the fact that the RBI may still not be done with tightening for FY07. Our expectation had however been for tightening earlier in March. Also, we had expected a reverse repo rate hike, Yesterday the finance minister had also highlighted the possibility of further monetary tightening.
Hence, the tightening is not altogether unexpected. Though, why would the central bank wait for the end of the financial year to hike rates still remains a question. We think there are three immediate reasons why that should be the case:
> Rupee appreciation: The rupee appreciated to an almost 8 year high of INR 43.03 during intra day trading on March 28. There was no evidence of RBI intervention during this day. The rapid buildup in RBI’s foreign exchange reserves over the last quarter may have been responsible for this. The central bank has added on an average USD 1.8 bn every week and the total foreign exchange reserve kitty is currently at USD 197.7 bn.
> Possibility of continued strong external flows: Closely related with the previous point, is the likelihood of strong flows. The balance of payments data released today for Q3 FY07 suggest a comfortable external position. There are two points that merit being highlighted in the current context – (i) Despite a slowing down in the US economy in the same quarter to 2.5% from 3.5%, services exports remain strong and (ii) Even while portfolio investments into India have been erratic over FY07 so far, FDI flows are strengthening. Q3 numbers suggests that flows to India are likely to remain robust despite softness elsewhere. This in turn may lead to an appreciation
in exchange rate, which the RBI may not be comfortable with.
> Little letup in credit numbers even till year end: Figures released by the RBI today put the credit growth figures for March 16 at 29%. This is still above the comfort growth of 25% indicated by the RBI. Faster than expected credit growth in turn keeps inflationary fears alive.

What will be the impact of tightening?
The latest move suggests that:
> The RBI is unlikely to undertake further monetary tightening in the April 24 policy meeting. External flows and credit growth are likely to be closely watched indicators for the RBI going forward. The CRR is likely to remain the central bank’s preferred instrument of monetary tightening. Further tightening will likely depend on external flows.
> If the latest move results in further hiking of lending rates by commercial banks. Barring further tightening by the RBI, growth will likely sustain at 8-8.5% as opposed to 9% in FY07.