Backed by splendid year-on-year growth in manufacturing sector and rising farm output, Indian economy grew at the fastest rate in the past three years in the June-ending quarter. While the economy expanded by 8.8%, the manufacturing sector grew by 12.4% and annual farm output rose by 2.8%.

The latest growth figures reiterates the fact that Asia’s third-largest economy did not lose momentum during the period, despite the slow pace of global recovery and concerns of another round of economic downturn. The country also had to deal with the near double-digit inflation, which demanded strong fiscal measures.

The Reserve Bank of India was in a dilemma earlier whether to go all out in containing the runaway inflation without harming the amazing run of the economy. The central bank has stated time and again that containing inflation is being giving precedence to other policy objectives and followed it up by hiking interest rates four times in the last four months. The fact that economy is sound and steady gives RBI ample space to maneuver and focus on inflation-control fiscal tightening measures.

The consistency in economic growth is mostly due to the buoyancy in the domestic consumer market. This is thoroughly reflected in the automobile sales, which rose by 38% in July, forcing car manufacturers to run their factories to the optimum capacity.

The manufacturing sector witnessed a robust growth of 12.4% y-o-y. This growth is substantial when compared to the growth percentage of 3.4% for the same period last year. The agriculture sector expanded by a healthy 2.8% during the quarter. The trend is expected to continue on good monsoon forecast.

The sturdy growth may prompt RBI to go in for another rate hike during its quarterly policy review scheduled on September 16.

With the economy on the upswing post-recession, Indian banks are riding high due to increase in demand for loans and decrease in bad loans. This is expected to show up in the first quarterly results.

The country’s leading lenders, State Bank of India, ICICI Bank and HDFC Bank are witnessing a steady climb in demand for loan over the past few months. Another positive phenomenon seen is the drop in the number of loan defaulters, resulting in improvement in the quality of assets. With the economy predicted to grow beyond the government forecast of 8.5% in the current fiscal, there is a definite surge in confidence level all around.

The intermittent rate hikes by the Reserve Bank of India to combat the spiraling inflation has largely left this feel-good atmosphere untouched. The imminent RBI policy review scheduled for July 27 may also see another marginal rate hike, without any impact on the loan demand.

One of the reasons attributed to this is the presence of ample liquidity in the system. The rate hikes are too small to have any effect on the system. Moreover, the amazing growth of the economy is opening up lucrative avenues for the banking sector. The first quarter also witnessed the unbelievable competition among telecom providers in securing the 3G spectrum and their subsequent clamber to cough up adequate money to pay the spectrum fees to the government.

The superb performance of the manufacturing sector in the last few months has led to a substantial reduction in bad loans and defaulters. The first quarter of the current fiscal saw a drop of 30 basis points in the 10-year benchmark bond yield, which is beneficial from bank’s perspective.

The annual bank credit stands now at 21.7%, which is a tremendous improvement from 9.7% last October.

With the next quarterly policy review due by month end, the Reserve Bank of India has raised the interest rates by 25 basis points. The announcement to this effect was made on Friday after the financial markets closed for the weekend. The central bank attributed the rate hike to runaway inflation that is turning ‘very much generalized’ with demand-side pressures becoming evident.

The RBI raised the reverse repo rate from 3.75% to 4% and repo rate from 5.25% to 5.5%. This is the third time this year that the central bank has increased the interest rates.

The country’s wholesale price inflation (WPI) breached the 10% mark in May, even as industrial production surged ahead with a 17.6% increase in April. Moreover, the government’s recent decision to deregulate petrol prices and partially deregulate diesel prices is believed to further worsen the inflation situation.

“Although entirely justified in terms of long-term fiscal and energy conservation objectives, the recent increase in fuel prices will have an immediate impact of around one percentage point on WPI, with second-round effects being felt in the months ahead,” said a RBI release.

Though RBI announced the rate hike, the banks are in no hurry to raise their base rates. The base rate is the lower limit fixed for each bank below which it cannot lend.

The Finance Minister Pranab Mukherjee expressed his happiness at the latest RBI move. He termed RBI measure as ‘desirable given that core inflation has risen and credit situation is tight’. He is also satisfied that RBI has not hiked the cash reserve ratio (CRR) of banks.

“The measures should contain inflation and anchor inflationary expectations going forward, while not hurting the recovery process,” an RBI statement said. “The Reserve Bank will continue to monitor the macroeconomic conditions, particularly the price situation, and take further action as warranted.”

Economists are expecting a similar policy rate hike during the quarterly policy review scheduled on July 27.

The banking sector’s benchmark, prime lending rate (PLR), had been in the center of controversy for long, which prompted RBI to constitute a panel to look into the issue in detail. According to the panel’s recommendation, the PLR system is being abandoned and a new system based on base rate is being introduced. One of the advantages of base rate system is that it will make lending process more transparent.

O P Bhatt, Chairman, SBI, India’s largest bank said, “The base rate will be transparent. Credit will henceforth revolve around the base rate as it will be the reference rate over which all loans will be priced and it will succeed in monetary transmission.”

One of the perennial complaints against PLR system was that many private sector banks were not passing on the reduction in policy rates to customers, but lose no time when the policy rates are hiked. This equals nullifying the monetary policy. The banks are also accused of favoring their corporate customers at the cost of individual customers and smaller companies, with the latter forced to bear the financial consequences. Many banks are lending lower than even funding cost to their most valuable clients.

A base rate system can solve the existing maladies plaguing the banking sector at present. The base rate is the rate below which a bank cannot lend even to their most favored customers. This is determined after analyzing a bank’s funding cost and operating cost.

With the base rate system coming into effect today, Indian banks will be forced to stop lending below 7%. The base rate for different banks will be in the range of 7%-8.75%, depending on each bank’s funding cost.