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Reddy's Dilemma

October 17, 2007

Indian bankers seem to be taking a cue from US Federal Reserve Governor Ben Bernanke who slashed the short-term US rate for the first time in four years by 50 basis points to 4.75 per cent in September.

While Bernanke’s move was clearly directed at protecting the world’s biggest economy from a possible recession, Indian bankers, led by the two biggest lenders, State Bank of India and ICICI Bank, reacted this month by cutting floating interest rates on home and auto loans by 25-50 basis points. Is this a pointer to what RBI Governor Y.V. Reddy will do when he unveils the second quarterly review of monetary policy on October 30?

Y. V. Reddy
Y. V. Reddy

There is a strong case for lowering interest rate to pump up demand in the economy. There are already signs of a slowdown in retail credit, especially in the home and auto loans segments. The Index of Industrial Production (IIP) slipped into single digits in July, before improving again in August. The latest inflation rate figure, at 3.2 per cent, is also very encouraging.

However, overflowing liquidity in the market, especially on the back of record FII inflows of $16 billion, dilutes the argument in favour of a rate cut. With the US economy still grappling with the fallout of the subprime crisis, international investors are pouring money into countries like India and China.

Result: the rupee has appreciated almost 12 per cent to $39.45 since January this year. This is hitting exporters hard. If dollars keep flowing into India, Reddy will have no option but to address the demand of exporters by buying dollars to arrest the rise of the rupee. A natural corollary: the liquidity arising out of RBI’s action has to be sucked out by raising interest rates.

So, there are strong arguments in favour of both raising and cutting interest rates. To complicate matters further, the third alternative—that of maintaining status quo—is also very attractive. Despite a few scares, like the August IIP figure, the overall economy is still growing at over 9 per cent, making it difficult to make out a fool proof case in favour of a slowdown. Taking this argument further will lead to the logical conclusion that there is no case to reduce rates. Also, it can be argued, market dynamics will ensure that dollar inflows slow down once Dalal Street becomes too expensive for profitable investments.

Reddy has maintained a Sphinx-like silence on which way he will bend. Whatever he does, this will be one of his most eagerly anticipated announcements ever.

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