Market Insight RBI S ANNUAL POLICY (FY 11) A PERSPECTIVE SALIENT POINTS

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1 Market Insight APRIL 20, 2010 RBI S ANNUAL POLICY (FY 11) A PERSPECTIVE SALIENT POINTS Monetary Measures: - Repo and Reverse repo rates (refer glossary) increased by 25 bps to 5.25% and 3.75% respectively, with immediate effect. - Cash Reserve Ratio (CRR) also increased by 25 bps to 6% (to take effect from the fortnight of April 24, 2010). - Bank rate unchanged at 6% The baseline projection for inflation (WPI) for March 2011 is 5.5% and is expected to be driven by progress of monsoons, crude oil prices and demand-led pressures. GDP projections for FY 11 are at 8% with an upward bias aided by strength in manufacturing and services sector (a normal monsoon season is assumed). Projections for money supply (M3) growth and non-food credit growth at 17% and 20% respectively. Infrastructure Financing: Infrastructure companies will now be allowed to securitize receivables and substandard infrastructure loans will now attract a provisioning of 15% instead of 20%. Also banks will now be allowed to classify infrastructure bonds with residual maturity of 7 years under hold-to-maturity category (rather than mark-to-market). New Securities: Recognized stock exchanges will be allowed to introduce plain vanilla currency options (spot US Dollar/Rupee) and Interest Rate Futures, and new guidelines expected on Credit Default Swaps (CDS). Source : RBI, Citigroup FT S VIEWS The Annual Policy for FY11 was largely along expected lines, but the quantum of hikes was lower than expectations of few market players.the latest monetary measures and policy review clearly reflect the increasing emphasis on reining in inflationary pressures. While economic growth has been strong; the central bank has highlighted possible risks due to an uncertain global environment and erratic monsoons. 1

2 WPI inflation Source: JP Morgan RBI has highlighted the shift in the composition of inflationary pressures from supply-led constraints to demand-led factors. Increased capacity utilization and higher global commodity prices are also concerns. The higher credit growth expectations seem to be in line with the 8% GDP growth expectations (with an upward bias).the economic growth is expected to be spurred by strengthening exports/service sector activity; increased fund raising activity, and improved corporate profitability. This strong economic growth and the potential for relatively higher earnings growth has led to increased foreign inflows into India leading to a strengthening of the currency.the ultra accommodative monetary policies in the developed world should lead to increased inflows into emerging market countries like India, with strong growth prospects.the RBI doesn t seem to be overtly perturbed about the quantum of flows, given the improved absorptive capacity of the economy compared to the past. Also given the lingering global concerns, RBI appears to be taking a sanguine view on inflationary trends by the end of FY 11 and doesn t want to impact the current growth momentum. The new norms for infrastructure-related companies and securities appear to be in line with this thought process and are aimed at boosting investment activity. MARKETS Bond yields eased from highs and closed below yesterday s levels as the quantum of rate hikes was less than expectations of some market players. Yesterday s close Today s close 1-year Gilt yield 5.40% 5.30% 5-year Gilt yield 7.69% 7.59% 10-year Gilt yield 8.08% 7.98% 5-yr Corporate Bonds (AAA) 8.48% 8.40% Equity markets have gained due to the absence of aggressive monetary tightening with interest-rate sensitive sectors in particular moving up sharply - Equity Indices (% change since yesterday s close) BSE Sensex 0.34 BSE Bankex 1.53 BSE Realty 3.08 As on April 20,

3 OUTLOOK Inflation and global oil prices will continue to weigh on market sentiment and monetary policy direction. We don t see the rate hikes impacting economic growth, rather these hikes need to be seen as a preemptive move to mitigate inflationary pressures and preventing asset bubbles. In any case, the inflationary pressures are largely due to the low base effect and supply constraints along with poor rainfall last year.the government needs to address the supply bottlenecks and have a contingency plan in place to address any deficient rainfall in the future. The government s fiscal consolidation roadmap is a positive, but as RBI has pointed out in its policy statement, the level of government borrowings is a key concern in FY 11. Unlike FY 10, a lot of the borrowings need to met mostly through fresh issuances (unlike FY 10 where most of the borrowings were supported through unwinding of MSS/OMO (refer glossary),muted credit growth and higher liquidity) Source: RBI, Economic Survey, Ministry of Finance, Morgan Stanley Research Given that a conducive environment is required to manage the government s borrowing programme - we don t expect short term yields to move up sharply at this stage. In addition, sterilization of the strong capital inflows should aid liquidity levels and keep short term rates in check.also given the relatively lower credit growth and buoyant financial markets, we don t expect any substantial upward movement in borrowing costs Overall, the monetary conditions continue to remain very accommodative of growth given that interest rates remain at multi-year lows.the yield curve has maintained its recent steepness - 1/30 year gilt spreads remain at highs. As credit demand from the private sector picks up momentum, we could witness a movement in interest rates in the second half of FY 11, depending on the liquidity levels/interest rate direction in developed markets. RBI s comments indicate a high possibility of inter-policy moves, depending on the macro factors. The yield curve is expected to remain steep and we will continue to focus on opportunities in corporate debt and high-yielding securities along with trading opportunities to take advantage of any sweet spots across the yield curve. We expect short duration bond funds to provide superior risk-adjusted returns. Corporate India s healthy track record in terms of RoE as well as greater proportion of domestic demand component in earnings is a positive.this has led to a contraction of corporate spreads and has also helped the equity markets enjoy a valuation premium over other emerging markets. However, investors need to watch out for overpricing of growth in certain pockets. 3

4 GLOSSARY Cash Reserve Ratio / Statutory Liquidity Ratio (CRR/ SLR): CRR is the percentage of total deposits a bank has to keep with RBI in cash or near cash assets. SLR is the percentage of its total deposits a bank has to keep in approved securities. The purpose of CRR & SLR is to influence liquidity levels.when banks have to keep low CRR or SLR, it increases the money available for credit in the system.this eases the pressure on interest rates and they tend to move down.also when money is available at lower interest rates, it tends to push credit offtake to industry and in turn lead to higher economic activity. Repo/ reverse repo (repurchase/ reverse repurchase agreement) : Typically the RBI provides or absorbs excess systemic liquidity on an ongoing basis by conducting repo/ reverse repo auctions at a rate specified in the credit policy. The repo rate is the annualized interest rate chargeable for the funds transferred by the RBI to the borrower. On the other hand, reverse repo rate is the rate at which RBI is willing to borrow from banks RBI normally hikes the repo rate to curb inflation and increase in asset prices. A higher repo rate means the central bank is willing to borrow short-term money at a higher rate.this prompts lenders to ask for a higher compensation from borrowers and thereby mitigates demand led inflationary pressures as well as speculative activity. Bank rate: Benchmark rate at which RBI refinances banks and primary dealers. It is used as a reference rate to signal the interest rate policy of the central bank the rate has been maintained at 6% since April Open Market Operations (OMO): refer to transactions where the RBI buys or sells Government Securities to/ from participants in the financial markets, with the objective to absorb or provide liquidity in the market.thus, OMO is a tool of monetary policy and in the past when excess capital inflows had to be absorbed, OMOs were used to sterilise such flows. Money supply: is the amount of money in circulation in the economy at any point of time. It includes the currency & coins in circulation and demand & time deposits of banks, post office deposits etc. Different components of money supply are as under: M1 = Currency with the public + Net demand deposits of banks + other deposits with RBI M2 = M1 + Post Office Savings M3 = M2 + Net Time Deposits M3 is the level of money supply in an economy at any given point of time. Market Stabilization Scheme (MSS): This programme was launched in 2004 with RBI issuing MSS bonds to soak up excess liquidity in the system caused by massive inflow of foreign capital. The average outstanding MSS balance stood at Rs 128,684 crore in FY08 and Rs 148,889 crore in FY09. This has however reduced sharply now with MSS unwinding undertaken to deal with the reduction in systemic liquidity caused by foreign capital outflows and high government borrowings during FY09 and FY10. 4

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