India raises repo rate to 7.5% in surprise move

India’s new central bank governor Raghuram Rajan surprised markets today by raising the repo rate – the rate at which the central bank lends to commercial banks overnight – to 7.50% from 7.25%.

Economists had widely expected Mr. Rajan, who took over as head of the Reserve Bank of India earlier this month, to keep rates unchanged in spite of the current inflation rate.

This is the first rise in two years.

Even as India struggles with an economic slowdown and a global sell-off in emerging market assets, it is clear that Mr. Rajan is committed to fighting inflation.

India’s economy is expected to grow by less than 5% this year, a very low rate compared to its average annual growth rate over the last ten years.

India raises repo rate to control inflation

Mr. Rajan, who worked as an economist in the International Monetary Fund, has reiterated that for him India’s inflation is his top priority.

Keeping inflation under control will lead to a stable currency in the long term and help India achieve sustainable growth, he added.

India’s annual inflation rate reached a six-month high of 6.1% earlier this week.

The percentage of banks’ deposits that must be kept in cash – the cash reserve ratio – remains unchanged.

At a press conference, Mr. Rajan said:

“Bringing down inflation to more tolerable levels warrants raising the repo rate by 25 basis points immediately.

To the extent that we can anchor inflationary expectations, we can create a sense of stability in the value of the currency, [and] the economy is actually better off from a growth perspective.”

India raises repo rate to the dismay of markets

The 30-share S&P Sensex dropped 1.9% today, while the rupee fell by almost 1%. Bond prices also dropped steeply with the benchmark bond yield rising to 8.58% (from 8.19% at yesterday’s close).

The BBC quotes Anjali Verma, chief economist at PhillipCapital as saying “Hiking the repo rate was unexpected. The governor is clearly worried about inflation. He is saying the improved international conditions will take care of the current account deficit funding and his focus will shift to fiscal deficit and inflation, which were taking a backseat.”

The Reserve Bank of India has cut the cost of funds that can be borrowed through an emergency lending facility of the central bank. Mr. Rajan said that this will reduce the cost of bank financing, despite the higher central bank rate.

Other emerging economies have been also been raising central bank rates as they attempt to tighten monetary policy, examples include Indonesia and Brazil.

As most of the world had expected the U.S. Federal Reserve to scale down its stimulus program (pumping $85 billion every month into the American economy), emerging markets have been struggling to stem the exodus of foreign currency.

Surprisingly, the Federal Reserve decided to keep the stimulus program intact.

In an online press statement, Mr. Rajan said:

“At the Reserve Bank of India, my colleagues and I have been busy developing the measures we announced about two weeks ago. Yesterday, the RBI implemented the full liberalization of bank branching, with some safeguards to encourage inclusion. We announced both the FCNR(B) swap facility as well as the swap facility for bank borrowings.

I am glad to say that banks have started bringing in money. Till yesterday, we had received $466 million through the FCNR(B) and $917 million through the swap facility to a total of nearly $1.4 billion. We have started the process to issue two kinds of retail inflation indexed retail certificates, one with a lump sum payment at the end and the other with indexed interest payments. We have set up the central credit registry for large bank borrowers. The various committees we announced are swinging into action.

Over the next few weeks, together with the government, we will take a close look at corporate distress and bank NPAs to see how we can accelerate the process of resolution.

Finally, we are taking a look at a variety of markets to deepen them and make them more vibrant. Measures will be announced periodically.”