The Reserve Bank of India (RBI) has surprised financial markets by announcing the following
changes:

l The Repo Rate (rate at which the RBI infuses liquidity in the banking system) is hiked by 50
basis points to 8% pa with immediate effect

l The Reverse Repo Rate (rate at which the RBI absorbs surplus liquidity from the banking
system) is hiked by 50 basis points to 7% pa with immediate effect

l Headline inflation target for March 2012 is increased from 6% to 7% YoY

l All other rates are kept unchanged

Most of the market participants were expecting the RBI to hike both Repo Rate and Reverse Repo
Rate by 25 basis points.

In its first quarter review, the RBI has noted the current uncertainties in the global financial
markets which could have a negative impact on the key commodity prices in the near-term. The
RBI has also acknowledged slowing momentum of growth impulse. Instead, the RBI has chosen to
focus exclusively on two important facts:

l Rising inflationary pressures in the near-term, and

l fears of a fiscal slippage in FY2012

The RBI has noted that headline inflation continues to remain elevated and could remain elevated
for some more time. At the same time, although the growth impulse has moderated a bit in
recent weeks in some rate sensitive sectors, it is still above trend-growth due to expansion in
the services sector of the economy and that the overall growth rate is unlikely to slow down
significantly from its current level in the near-term.

Therefore, hiking interest rates by 50 basis points, the RBI hopes to curtail demand for goods and
services in the near-term. At the same time, the RBI would like to see a modest expansion in the
output with the aim to offset price pressures in the medium-term.
Predictably, the RBI has decided to maintain a hawkish bias with an aim to bring down inflation
below its target level. What that means is the RBI may continue to hike rates until the headline
inflation is under control and the growth impulse is above trend-level.
In line with its current assessment, the RBI has also reduced the projected growth in M3 from 16%
to 15.5% and non-farm credit growth target from 19% to 18% by March 31, 2012.
Impact on Financial Markets:

l Government Bonds: Benchmark 10Y government bond yield rose by around 10 basis points
to 8.40% pa immediately after the announcement. Market participants are likely to reduce
their exposure to government bonds in the near-term ahead of the scheduled auction of `
12,000 crore of benchmark 7Y, 10Y and 30Y government bonds on Friday July 29, 2011 amid a
change in market sentiment. We expect the benchmark 10Y yield to gradually head towards
its previous peak of 8.45% pa in the near-term. Lack of any positive triggers and uncertainty
in the global financial markets may weigh on the sentiments of bond market participants and
may prevent them from adding duration even though there is value in government bonds at
the current levels.