The Finance Minister, P. Chidambaram said that there has been a sharp increase in priority sector advances of PSU banks. The SME credit has totalled Rs 184589 crore registering an increase of 25.81% YoY, he added.

The RBI is concerned with liquidity, Chidambaram said. By increasing the CRR, the RBI has sucked out Rs 15000 crore of liquidity from system, he said, adding that the concerns are valid.

He informed that there has been a net impact of the CRR hike & Reverse repo window opening; the net impact on NIMs would be 0.03% . The PSU bank balance sheets are healthy and will absorb this small hit, Chidambaram said. He said that banks are inclined to lower their deposit rates on 1-year term deposits by about 50 bps. Already some banks have lowere 1 yr deposit rates to 8.5% from 9%.

He maintains that there would be no serious impact of the new monetary policy announcement. He projects the credit growth at 24% in FY08.

Yesterday, the RBI announced a hike in banks' cash reserve ratio by 50 bps to 7% in an effort to slow money supply expansion and as a signal for banks not to slash lending rates as monetary policy remains tight. But the central bank kept the repo, reverse repo and bank rates unchanged.

A higher priority for managing "appropriate" liquidity conditions in the policy hierarchy has been accorded at the current juncture, the RBI said in its first quarterly review of the 2007-08 (Apr-Mar) Annual Policy.

Worried about the acceleration in money supply and reserve money--which are threats to inflation--the RBI said banks will have to keep aside 7% of their demand and time liabilities, or an additional 150 bln rupees, from Aug 4 as cash reserves. Including today's hike, the RBI has raised the CRR by 200 bps since December. The RBI also said it was lifting the 30-bln-rupee cap on reverse repo bids, from Aug 6, it accepts to drive up overnight rates, and to provide an alternative to banks to deploy overnight funds relatively more remuneratively.

The RBI, however, warned that it may re-impose the ceiling on the reverse repo bids it accepts if monetary conditions warrant. The RBI also scrapped the second repo and reverse repo tenders it conducts every day under its liquidity adjustment facility from Aug 6. The central bank will continue to actively manage liquidity through CRR, Market Stabilisation Scheme and LAF, using all the instruments, as and when the situation warrants, RBI said in its review.

CRR HIKE IMPACT
Government bond yields rose and share prices, especially banking ones, fell sharply as the hike in CRR took some market players by surprise. Earlier, expectations were that the RBI may not resort to any extreme
monetary tightening step because inflation was under control and banks' credit growth had decelerated. "It is more hawkish policy than what was expected. From September, call rates will move to 7.75-8.00% and stay at these levels for six-to-eight months. RBI will have to keep tightening policy for controlling inflation,"
Shailendra Jhingan, debt fund manager, HSBC Mutual Fund said. Jhingan expects another 50 bps hike in CRR by Oct-Nov.

Banking shares rose and bond yields fell in the run up to the policy review. The RBI is worried that growth in money supply and reserve money was above estimates. As on Jul 6, year on year growth in money supply, or M3, at 21.6% was way above the RBI's target of 17.0-17.5%. Reserve money expanded 29.1% on year, up from 17.2% a year earlier. "The central bank sees inflationary pressure from liquidity and high growth in credit," said Kotak Mahindra Bank Chief Economist Indranil Pan. "With the demand pressure high in the economy, the monetary stance continues to be tight."

"The central bank does not want excess liquidity in the system," said YES Bank Chief Economist Shubhada Rao. The CRR hike is not expected to tighten liquidity significantly, bankers said. The step only modulates the availability of funds. "I do not see banks raising lending rates due to the CRR hike. In a period where credit growth appears to be declining, raising lending rates is not an option banks will look at," Rao of YES Bank said. Some banks even appeared defiant to the hike in CRR, and said lending rates are bound to come down.

"The CRR hike will not stop interest rates from coming down. Deposit rates have already started coming down, lending rates will also fall. The current interest rates are at unusual level, so they should come down," said
IDBI Chairman Yogesh Agarwal.

TAKE AND GIVE
While raising the banks' cash reserves, the RBI has also ensured that banks get compensated more for their surplus liquidity. The RBI removed the 30-bln-rupee ceiling on reverse repo tenders. This means that the RBI will pay 6% for a greater amount bids at its tenders. The RBI pays no interest for the CRR maintained by banks. The RBI also scrapped second set of repo and reverse repo tenders.

"This was required. It was creating artificial liquidity and artificially lowered overnight rates to 0.50%," said Jayesh Mehta, managing director and head of debt markets, DSP Merrill Lynch. The removal of the reverse repo cap meant that the corridor for overnight rates will be restored between 6.0-7.75%. "The sanctity of the LAF corridor is reinstated, which lost its relevance after the overnight rates fell to near-zero levels in the last one month," said a bond dealer.

"The move also means that focus is back on active liquidity management," another dealer said. Liquidity has surged due to the RBI's dollar purchases, government's cash balances, rising bank deposits and foreign credit.

INFLATION OUTLOOK
Monetary management would need to be watchful of movements in commodity prices, particularly oil prices, and elevated levels of asset prices, the RBI said. "The re-emergence of pricing power among producers is a potential threat to inflation expectations," it added. "While the central bank has said headline inflation has turned benign, it would definitely monitor pressures on inflation from higher crude oil prices and demand side pressures," YES Bank's Rao said.

Risks to inflation outlook persist owing to rising crude and food prices in global markets, the RBI said retaining its inflation target for 2007-08 to within 5% and 4.0-4.5% in the medium term. "It is necessary to continuously assess the risks to the inflation outlook emanating from high and volatile international crude prices, the continuing firmness in key food prices and the uncertainties surrounding the evolution of demand-supply gaps globally as well as in India," the RBI said in the statement.

Crude prices are hovering close to their record highs of $ 78.40 a barrel leading to fears of a hike in domestic fuel prices leading to rise in inflation and in turn interest rates. "Domestic prices of petrol and diesel, have undergone two downward revisions during 2006-07. It is necessary to recognise the need for some more pass-through from recent movements in international crude prices," the RBI said.

Currently, the headline inflation, based on Wholesale Price Index, is at 4.41% compared with 4.27% a week ago. The rise in inflation was mainly due to increase in primary article prices. Demand pressures appear to be stronger than before, while uncertainty over supply has increased due to rising crude prices, the RBI said. There are concerns over sustainability of high growth, the RBI said, even as it retained its forecast for GDP growth in 2007-08 at 8.5%. In view of the perceived threat from rising commodity prices and volatile financial markets, the RBI urged banks and corporates to mitigate risks and adopt prudent currency and interest rate strategies.

Other highlights:

RBI Policy: Removes Rs 3000 crore reverse repo cap from Aug 6
RBI Policy: Keeping inflation within 5% FY08 assumes priority
RBI policy reiterates 4-4.5% medium-term inflation aim
RBI Policy: Monetary stance spelt out in Apr retained
RBI Policy: Headline inflation has turned benign
RBI Policy: No second reverse repo, repo auctions from Aug 6
RBI Policy: Outlook for FY08 inflation remains unchanged
RBI Policy: Higher priority for managing "appropriate" liquidity
RBI Policy: Banks, cos must ensure currency, rate hedging plans
RBI Policy: Hedge funds pose significant risks to mkts
RBI Policy: Need to be watchful of commodity, oil prices
RBI Policy: Prospects for FY08 GDP growth appear positive
RBI Policy: Inflation pressures seen from liquidity, high credit
RBI Policy: Net capital inflows very strong so far FY08
RBI Policy: Crude, food prices rise risks to inflation outlook
RBI Policy: Risks to inflation expectation up on high oil prices
RBI Policy on inflation: Need to be watchful of high asset prices
RBI Policy: Domestic outlook continues to be favourable
RBI Policy: Liquidity gets higher priority in policy hierarchy
RBI Policy: Pvt equity funds' size risk to emerging mkt economies
RBI Policy: M3, reserve money rise warrants appropriate response
RBI:Inflation threat from re-emergence of producers' price power

Reacting to the policy, Ajay Mahajan, of Yes Bank said that he is expecting the bond market to rally significantly. He said that it was not expected from RBI to remove the reverse repo cap. Abheek Baruah, Chief Economist, HDFC Bank said that 91-day T-Bills may go up by 150 bps.

Nilesh Shah of ICICI Pru said that FMP products are likely to see increased action. He further said that the RBI seems to indicate that it may take swift actions to maintain growth momentum and manage inflation. Interest rates are unlikely to harden from current levels.

MBN Rao, Chairman, Canara Bank said that pressure on interest rates on deposits and lending rates may ease and the bank may cut deposit rates due to rate hikes by RBI. The lending rates may remain constant for some time.