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By V. Ramakrishnan and Charlotte Cooper
The Reserve Bank of India moved on Tuesday to drain surplus cash from the banking system stemming from strong capital inflows, knocking bonds lower, but it left its key interest rates steady, as expected.
The RBI, still sounding a fairly hawkish note after five rate increases since June last year, raised the proportion of cash banks have to keep with it on deposit to mop up funds that could fuel inflation.
The central bank raised banks' cash reserve ratio (CRR) to 7.0 percent from 6.50 percent with effect from Aug. 4, the fourth increase since early December, taking it to its highest level since November 2001.
"Monetary expansion has to be curbed," said Saumitra Chaudhuri, economic adviser at credit rating agency ICRA.
Economists said the central bank was probably not done raising the CRR, with six out of 10 polled by Reuters expecting another increase by March at the latest.
Tuesday's rise will drain nearly $4 billion from the system and the RBI also scrapped a 30 billion rupee limit on its daily money market operations to drain cash from the system, enabling banks to park more funds with it.
The yield on the 10-year government bond ended 8 basis points up at 7.84 percent soon after the decision on worries these measures would leave less cash to buy bonds.
The stock market briefly shed more than 1 percent, with banks and auto stocks hit particularly hard on concern that loan growth would fall, but later closed nearly 2 percent up.
The partially convertible rupee inched towards last week's nine-year high of 40.20 per dollar after the decision.
The RBI left its key repo rate unchanged at 7.75 percent and its reverse repo rate, at which it absorbs excess cash from banks, steady at 6.0 percent. The bank rate, used to price long-term loans, remained at 6.0 percent.
OTHER STEPS
India's move came a day after China, inundated with cash from its current account surplus, raised the level of deposits banks must hold in reserve for the ninth time in 13 months.
India's banking system has been awash with cash in recent months due to robust capital inflows into Asia's third-largest economy, particularly into the record-breaking stock market.
"Recent financial market developments in India and potential uncertainties in global markets warrant a higher priority in the policy hierarchy for managing appropriate liquidity conditions," the RBI said in a statement.
It scrapped one of its two daily money market operations from Aug. 6, and said it could use variable or fixed rates in repo and reverse repo auctions and conduct longer-term operations.
The RBI has been intervening to cap the rupee's gains, buying dollars in a policy that has generated excess cash in the money market.
As a result, overnight call money rates have hovered near zero for weeks, complicating monetary policy.
HSBC economist Robert Prior-Wandesforde said intervening to suppress the rupee while fighting inflation with firm interest rates was unsustainable, and he saw another reserve requirement increase later in the year along with more rupee gains.
"If inflows continue the way they have been, we will be witnessing a similar situation a couple of months later," he said.
The RBI said although headline inflation has eased below its 5 percent comfort ceiling, upward pressures persisted, with risks from high and volatile crude prices, demand-supply gaps and firm food prices.
Governor Yaga Venugopal Reddy told a news conference asset prices had begun to moderate but the central bank warned financial institutions to be prepared for higher volatility than before in financial markets worldwide.
However, domestic economic activity continued strong and the base appeared to be broadening, it said, and it retained its 8.5 percent growth forecast for 2007/08.
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