The Reserve Bank of India has kept key short-term interest rates unchanged in the annual policy announcement for the year 2006-07. The central bank expects economic growth to remain at current level and is confident that inflation can be contained below the target rate.

The policy announcement to keep interest rates steady has surprised the markets. Majority of economists and analysts were expecting the central bank to raise reverse repo rates by 25 basis points in the light of rising global interest rates and higher crude oil prices.

The central government is in favour of stable interest rates as it does not want to upset the economic growth momentum. The prime minister today once again mentioned the target of 10 per cent GDP growth, a key driver for which would be stable interest rates. The finance minister has often stated that further rate hikes are not warranted at this point of time.

Bonds have gained after the announcement while the Rupee is holding steady. The move helped the stock markets to gain further ground as stable interest rates would ease the pressure on corporate profitability.

Outlook
There are no major changes in the economic and policy outlook of the RBI for the current year. GDP growth projection for the current year has been maintained at close to 8 per cent. Target inflation has also been left unchanged, despite the fact that current inflation is lower than earlier forecasts.

It is well accepted that wholesale price index (WPI) based inflation in India does not capture the significant rise in commodity prices in the recent past. Much of the oil price rise is yet to reflect in retail fuel prices, holding price levels from rising further. If prices of oil continue to remain high, these higher costs would have to be passed on to consumers, which would push up price levels.

RBI maintains that 'downside risks to the economic outlook internationally continue in the form high and volatile oil prices, geo-political tensions and supply shocks, elevated asset prices, global imbalances and tightening of monetary policy globally.'

The reference to global factors and rising crude prices may be with a view to keep the policy options open. If oil prices maintain these levels or continue to rise and global interest rates rise further, the RBI can be almost certainly expected to hike rates at its next meeting.

Any further increase in the US Fed rate would force central banks of other major economies to hike their rates as well. Emerging economies like India with high economic growth rates would find it difficult to keep interest rates stable if the Fed rate is raised to 5 per cent or more.

The statement announcing the policy emphasise that the monetary policy would aim at enabling continuation of the growth momentum with price stability. The statement also emphasises the need to focus on credit quality and financial stability.

Easing the liquidity crunch
The banking sector has been complaining about tight liquidity conditions for some time now. Credit demand, both from the corporate and retail segments, has been growing at a record pace for the last many months. However, growth in deposits has not kept pace as other asset classes offered superior returns for retail investors.

It was expected that the RBI would reduce the CRR in the policy. It is estimated that every 100 basis points reduction in the CRR would release around Rs20,000 crore of additional liquidity into the system. However, the RBI has decided to maintain the CRR at the same level.

The only move to attract more deposits is the increase in ceiling rates on Rupee deposits by non-residents by 100 basis points. The ceiling rate on export credit in foreign currency has also been raised.

The statement from RBI assures that appropriate liquidity would be maintained to meet legitimate credit requirements. It is likely that the central bank is aiming to ease liquidity through more active repo operations, liquidity adjustment facility (LAF) and market stabilisation scheme (MSS).

Pre-empting asset price bubbles
Rising asset prices are worrying central banks across the globe. The US Fed has been voicing its concerns about rising property prices, which has a significant impact on the US economy, for quite some time now. Most stock markets across the globe have performed very well in the recent past.

The RBI, which has a strong reputation for being highly cautious, has raised standard asset provisioning by banks for capital market exposures, commercial real estate loans and retail housing loans above Rs20 lakh to 1 per cent from the existing 0.4 per cent.

Risk weight on banks' exposure to commercial real estate sector has been increased to 150 per cent from 125 per cent. Exposure of commercial banks to venture capital firms would be treated as capital market exposures and would attract higher risk weight of 150 per cent.

The move to tighten risk management policies and provisioning requirements for bank exposure to real estate and capital market segments is a precautionary measure to guard against fuelling asset price bubbles. The stock markets have rallied for the last few years and the indices are at all-time highs while real estate prices has seen phenomenal increases in the last couple of years.

A recent study by the National Housing Bank (NHB) had shown that home loan defaults have risen from around 2 per cent to more than 7 per cent in some areas. Any decline in the stock markets could throw up some bad loans in that segment as well.

Housing and personal loans may cost more
It is very likely that commercial banks would pass on the higher provisioning requirements through a modest rate hike on housing and commercial real estate lending rates. Rates on housing loans above Rs20 lakhs would rise.

Interest rates on personal loans may also move up marginally as the RBI has increased the standard provisioning requirement for personal loans as well. Large private sector banks like ICICI and HDFC Bank are the major players with significant exposure to the retail segment. It is unlikely that a marginal rate increase would impact retail loan growth even modestly.

However, it is not clear if the higher provisioning and risk weight are applicable for existing loans or only for fresh loans. If they are applicable on existing loans, banks would have to take a one-time hit for the quarter ending June 2006.

Highlights of the annual policy

• Reverse repo rate, the rate at which the RBI borrows money from the market, unchanged at 5.5 per cent per annum.
  
• Repo rate, the rate at which the central bank lends money, stays the same at 6.5 per cent.
  
• Bank Rate, more of a reference rate for fixing interest rates on medium and long term commercial borrowing, unchanged at 6 per cent per annum.
  
• Cash Reserve Ratio (CRR) for commercial banks also remains the same at 5 per cent.
  
• GDP growth forecast for 2006-07 at between 7.5 per cent and 8 per cent
  
• Target inflation range for 2006-07 at 5 to 5.5 per cent
  
• Credit growth forecast to slow down to 20 per cent from 30 per cent at present
  
• Bank deposits to grow by Rs3.3 lakh crore this year
  
• Tightens risk control measures for banks' exposure to real estate and capital market sectors