RBI lifts reserve ratio, rate rise seen next

The Reserve Bank of India (RBI) surprised markets by raising banks' cash reserve requirements by more than expected on Friday and warned of mounting inflation, setting the stage for increasing interest rates in the coming months.

The RBI kept short-term interest rates steady at its quarterly policy review but signalled hawkish intent that traders and analysts said could mean interest rates hikes even before its next review in April.

The RBI said that reversing its accommodative monetary policy would be ineffective unless the government cuts borrowing, on track to hit a record 4.5 trillion rupees ($97 billion) this fiscal year, putting pressure on the government to rein in spending when it releases its budget on Feb. 26.

"I think they're lining us up for something more in the not-too-distant future," said Robert Prior-Wandesforde, senior Asia economist at HSBC in Singapore, who expects a rate increase before the April meeting.

Stocks, bonds and the rupee all weakened in their initial reaction to the central bank's decision to raise the reserve ratio by 75 basis points before paring losses.

Investors had priced in a 50 basis point reserve rise as well as an increase in lending rates by April. Analysts' expectations for a rate increase in the next three months were little changed in a new Reuters poll after the policy review.

India is joining a trend in other major emerging economies towards gradual tightening of loose monetary policies.

This month, China started to tighten policy by raising banks' reserve requirements, clamping down on loan growth and accepting higher yields at bill auctions.

On Wednesday, Brazil -- another member of the BRIC quartet of emerging powers that also includes Russia -- held rates steady but left the door open for a possible rate hike.

Despite rising inflationary pressures, the Indian government has pressured the RBI to hold off raising rates, saying it could undermine economic recovery. Raising rates could also curb bank lending that has just started to recover, and spark potentially destabilising capital inflows.

"Although the RBI left policy rates unchanged, the tone of its rhetoric is fairly hawkish," Brian Jackson, economist at Royal Bank of Canada in Hong Kong.

"The increase in growth and inflation forecasts also suggests that policymakers are increasingly uncomfortable with keeping rates at current levels," he said.

(For a graphic on interest rates, inflation and output, see

r.reuters.com/wam56h)

MARKET MOVES LIMITED

One-year swap rates rose 11 basis points on Friday in anticipation of higher interest rates, but the reaction was limited in other markets on a view the central bank is unlikely to act before the government budget release in February.

"We think the Reserve Bank of India (RBI) has put the onus on the government to lower its deficit, both in terms of revenues and expenditure compression to make monetary policy more effective," Citigroup analysts said in a note.

Stocks initially extended losses to 2 percent before ending positive, with banks gaining 3 percent.

The partially convertible rupee ended at 46.16/17, stronger than Thursday's close of 46.35/36 on hopes of larger inflows. The benchmark 10-year bond yield closed at 7.59 percent, up from Thursday's 7.55 percent.

Traders said they expected no further rate action until after the Feb. 26 budget, with eyes on what the government does about its borrowing and a fiscal deficit on track to hit 6.8 percent of GDP in the current fiscal year.

"They may wait to see to what extent the government unwinds the stimulus measures," said A. Prasanna, economist at ICICI Securities primary dealership in Mumbai.

HIGHER INFLATION, GROWTH

The central bank lifted its wholesale price index inflation forecast for the end of the fiscal year in March to 8.5 percent from 6.5 percent and upgraded its economic growth forecast for the current fiscal year to 7.5 percent from 6 percent, predicting a similar rate of growth the following year.

It said it expected inflation to moderate from July, assuming a normal monsoon and steady oil prices, but the new forecasts convinced many analysts an interest rate rise was imminent.

The RBI said the CRR would be increased by 50 basis points from Feb. 13 and a further 25 basis points to 5.75 percent from Feb. 27.

It held its lending rate, or the repo rate, unchanged at 4.75 percent and its reverse repo rate, at which it absorbs surplus cash from banks, unchanged at 3.25 percent.

The cash reserve ratio was cut by 4 percentage points between October 2008 and January 2009 as the central bank moved to support the economy during the global financial crisis also slashing interest rates to their lowest levels since 2000.