The Reserve Bank of India's (RBI's) move on Friday evening, ahead of its policy meeting on April 20, to raise the repo rate (at which it lends to banks) and the reverse report rate (what banks earn when they park money with RBI) by 25 basis points each wasn't surprising given the high inflation. But, its timing surely was.
The expectation of higher inflation (projected at 11-12 per cent in the first half of 2010-11) suggests further tightening. "RBI is likely to increase both repo and reverse repo rates by another 25 basis in the next policy meeting. We believe the rates will witness cumulative tightening of 100-125 basis points during 2010-11," say Edelweiss analysts.
With the recent move, RBI has taken its first direct step towards increasing interest rates, marking a reversal of trend. As expected, stocks from rate-sensitive sectors fell on Monday. However, their future performance will depend on further policy action.
On Monday, the BSE Realty Index lost almost 4 per cent, as against the Sensex's 0.95 per cent decline. Higher interest rates may negatively impact the recovery in the sector, which is currently on a shaky ground.
In fact, the Realty Index has been an underperformer since end-October 2009, partly due to its significant outperformance during the March-October 2009 period. Even since the beginning of 2010, it has underperformed the Sensex, due to an increase in the cash reserve ratio in January 2010 and consequent rate hike fears.
In between, moves that led to a rise in input costs, together with the sector coming under the service tax net, added to its woes.
The BSE Auto Index fell 1.73 per cent on Monday. Though the rate rise is likely to impact demand, experts believe the impact is unlikely to be significant. According to analysts, companies have reasonably good bargaining power to pass on cost increases.
They also expect the sector to continue to do well on the back of the ongoing economic recovery and higher disposable incomes.
The BSE Banking Index also slipped, but by a lower margin of 0.85 per cent. The reason, analysts say, is the ongoing economic recovery, which should lead to good growth in the core business.
Banks haven't raised rates after RBI's move as they are busy meeting their year-end loan targets. But, they should do so in April and should be able to sustain their profit margins in the medium term.
The only risk in the near term is bond yields shooting up to over 8 per cent from about 7.9 per cent at present, which may hit their March 2010 profits.
