RBI Q1 FY11 Monetary Policy Review

RBI Q1 FY11 Monetary Policy Review

The Policy Measures In Brief In its First Quarter Review of the Annual Monetary Policy for 2010-11, the Reserve Bank of India increased its policy rates with immediate effect. Repo rate was increased by 25 bps to 5.75% Reverse repo rate was increased by 50 bps to 4.5% Cash reserve ratio was maintained at 6% Impact: Repo is the rate at which banks borrow from RBI and reverse repo is the rate at which banks deposit surplus funds with RBI. Both are used by the financial system for overnight lending to and borrowing from RBI. An increase in these implies that borrowing and lending costs for banks will increase and this will lead to overall increase in interest rates such as credit and deposit. The higher interest rates will, in turn, lead to lower demand and thereby lower inflation. CRR was kept unchanged at 6% because of persistent deficit liquidity situation. Market participants expected an increase of 25 bps in both reverse repo and repo rates. A higher than expected increase in reverse repo has been done as RBI wants to lower the corridor (or difference) between repo and reverse repo rates. This corridor is usually the range within which money market rates operate. So if repo rate is 5.75% and reverse repo rate is 4.5%, money market rates such as call, CBLO and NSE-Mibor rates should ideally be trading between 4.5% and 5.75%. This is because, as RBI is considered the safest counter-party, RBI rates act as the benchmark. Ideally, banks borrow/lend from/to other private sector counterparties at higher rates. So, if there is a bank with surplus funds, it will either place it with RBI at the reverse repo rate of 4.5% or lend it to a private counterparty facing deficit funds at a higher rate of interest. This way the lending bank charges for the higher counterparty risk. The corridor is widened in times of high uncertainty in the economy and financial markets. As money market rates turn volatile in such conditions, RBI widens the corridor so that money market rates do not trade outside it. The objective is to reduce volatility from rates to the extent possible. The corridor remained at 100 bps till October 2006. After October 2006, as inflation increased and there were signs of overheating in the economy, RBI widened the corridor significantly from 100 bps to 300 bps in July 2008. Then, as the ripples of the global financial crisis reached India in September 2008, the corridor was narrowed to 200 bps in October 2008. This was not because uncertainty was low, but because RBI cut the repo rate aggressively to prevent market panic. The corridor was further narrowed to 150 bps in November 2008 and has remained there since. RBI has been increasing the policy rates since March 2010. However, it has been increasing both repo and repo rates by the same amount. So, the corridor has remained at 150 bps, which has now been squeezed to 125 bps.

Apart from trying to remove volatility from the short term rates, the RBI has probably increased reverse repo rates also in preparedness for any unanticipated surge in liquidity. The on-going liquidity squeeze is currently showing no signs of letting up, since the usual government spending volumes are unlikely to make up for the deficit. Even after the scheduled repayment of Rs 36,000 crore of G-Secs on Wednesday (July 28, 2010), the system is likely to remain in deficit. The only liquidity source for now could be global capital flows. With central banks across the world maintaining accommodative monetary policies, this might trigger large capital inflows, as RBI acknowledges in its policy document. If the scenario materialises, RBI probably wants to be prepared for the eventuality. RBI s Domestic Outlook Growth RBI revised its growth forecast upwards at 8.5% for 2010-11 from 8% (with an upward bias) given in April 2010 policy. RBI governor D Subbarao s statement said growth prospects have improved since the last meeting in April 2010. There has been an overall improvement in all sectors. Agricultural production is expected to be better than last year because of a good monsoon. IIP trends indicate that the industrial sector continues to be robust. Corporate performance has been good as well with a pick-up in sales and profitability. The governor s statement also added that investment intentions are translating into action across sectors. Increase in exports and widening of current account deficit also suggests strong growth momentum. It is based on such a scenario that RBI has raised its growth projections, which is in line with other agency forecasts (Table 2). We have been covering these outlooks in our Economic Weekly editions. The IMF s forecast is for calendar year 2010 and is based on GDP at market prices whereas the others are based on GDP at factor cost. Inflation RBI s inflation projection for March 2011 has also been raised upwards from 5.5% to 6%. Inflation has remained a concern for RBI for more than a year. Earlier, it was driven by food prices. But now it has become more broad-based, with high inflation recorded in manufactured products too. And this is not just because of supply side constraints, but also due to demand-side pressures. As economic conditions improved, demand for goods and services increased, leading to such a situation. RBI s Indicative Projections For 2010-11 (%, YoY) GDP Inflation (based on WPI, for March end) Money Supply (March end) Apr 10 Policy 8 with an upward bias Jul 10 Policy 8.5 5.5 6 17 17 Credit (March end) 20 20 Deposit (March end) 18 18* Note: Deposit growth rate has not been indicated in July-10 policy, we take it same as April 10 policy as RBI expects monetary outlook to be similar to April 2010 policy Source: RBI GDP Projections By Various Agencies (in %, YoY) RBI Earlier Projection Latest Projection 8 with an upward Apr-10 8.5 Jul-10 bias PMEAC 8.2 Feb-10 8.5 Jul-10 Finance Ministry IMF (for CY 2010) 8.5 (+/- 0.25) Feb-10 -- Not updated 8.8 Apr-10 9.4 Jul-10 ADB 8.2 Apr-10 8.2 Jul-10 OECD 7.3 Nov-09 8.3 May-10 NCAER 8.1 Apr-10 -- Not updated Source: RBI RBI said that since the April 2010 review, prices of many administered/regulated items such as petroleum products, iron ore and electricity have risen. The recent

partial deregulation and increase in administered prices of petroleum products will also have an inflationary impact in the short term. The immediate impact will be about one percentage point on WPI inflation, with the second round effects coming through in the months ahead. And if global oil prices rise further, the impact would deepen. Besides, the minimum support prices too have been increased, which will further fuel inflation. Overall, inflation continues to remain a major concern for RBI. However, inflationary expectations have not increased as per the RBI s quarterly inflation expectation survey conducted in June 2010. RBI said the inflation outlook will depend on three factors: Monsoon is going to be critical. A good kharif harvest will act as a major dampener on short-term food price inflation. Global energy and commodity prices, which, in turn, depend on global outlook. Recently, prices have softened because of increase in uncertainty. But, if the outlook improves and prices rise, it could push up WPI inflation. Domestic growth outlook, if it keeps improving, could lead to further demand-side pressures. RBI will continue to maintain its vigil on inflation and inflationary expectations. RBI also has said the conduct of monetary policy will continue to condition and contain perception of inflation in the range of 4-4.5%. This will be in line with the medium-term objective of 3% inflation consistent with India s broader integration into the global economy. As expected inflation is still much higher than the preferred range of 4-4.5%, one could clearly expect more interest rate hikes in future. This is also in line with RBI s statement to normalise interest rates given the growth and inflation outlook. Monetary aggregates RBI has kept projections for monetary aggregates unchanged. Currently, the growth rate for credit is higher than projections and that for deposits and money supply is lower. Yet, RBI believes monetary aggregates will evolve along the projected trajectory given in the April 2010 review. Surprisingly, RBI has not given any projections for deposits. We believe it could be because of an error and assume the deposits projections as the same as the one given in April 2010 at 18% Risk Factors There are several risk factors associated with the above projections. The most important is the emerging global outlook, which remains highly uncertain after nearly three years of crisis. If global recovery falters, it could impact exports, capital flows, inflation and overall economic activity. Overall economic activity: If there is a widespread slowdown, it could impact the Indian economic outlook as it happened post the Lehman collapse -- growth dipped from over 9% to 6.7% in 2008-09. Exports: A widespread slowdown in global trade will hit exports. There are already concerns that exports might slow down because of the ongoing European sovereign debt crisis. Capital flows: We could see a potential slow-down in capital inflows. Even if both exports and imports slowdown, the current account deficit is expected to remain high, as imports are expected to grow faster than exports. Besides the problem of managing the rising import bill, a slowdown in capital inflows may also constrain domestic investment -- critical to achieving and sustaining high growth. However, the risk of capital flows runs both ways. Central banks in advanced economies are likely to maintain accommodative monetary policies for an extended period. As India is expected to grow at higher rates, it is likely to trigger large capital inflows, which, if and when they breach the Indian economy s absorptive capacity, could pose a challenge for monetary and exchange rate management. Hence, both shortage and surplus of capital flows pose problems.

Inflation: Slower global growth will help lower energy and commodity prices. Unutilised global capacity in many sectors will also ease pressure on prices. With respect to controlling inflation, the global scenario may generate some favourable impulses. Policy Stance In the backdrop of the above analysis, the policy stance is pretty clear. It is to manage inflationary expectations keeping a close watch on the emerging global economic scenario. As deficit liquidity remains (liquidity is critical for monetary transmission) managing it actively will also remain a policy task. The table below looks at the policy stance since January 2010. It remains broadly unchanged. Comparing RBI s Policy Stance January 2010 Policy April 2010 Policy July 2010 Policy Anchor inflation expectations, while being prepared to respond appropriately, swiftly and effectively to further build-up of inflationary pressures. Actively manage liquidity to ensure growth in demand for credit by both the private and public sector is satisfied in a non-disruptive way. Maintain an interest rate regime consistent with price, output and financial stability. Anchor inflation expectations, while being prepared to respond appropriately, swiftly and effectively to further build-up of inflationary pressures. Actively manage liquidity to ensure growth in demand for credit by both the private and public sectors is satisfied in a non-disruptive way. Maintain an interest rate regime consistent with price, output and financial stability. Contain inflation and anchor inflationary expectations, while being prepared to respond to any further build-up of inflationary pressures. Maintain an interest rate regime consistent with price, output and financial stability. Actively manage liquidity to ensure that it remains broadly in balance so that excess liquidity does not dilute the effectiveness of policy rate actions. Source: RBI Summary The RBI monetary policy outlook was broadly in line with expectations. Barring a higher-than-expected increase in reverse repo rate, most of the actions were expected. Policy challenges will, however, remain. Though the Indian economy is expected to grow, the path ahead remains unclear due to two reasons: uncertainty about how the monsoons will behave in the next two months and the continuing global uncertainty. Market Reactions To Monetary Policy: G-sec: The benchmark 10-year 7.80% GS 2020 yield was trading at 7.67% before monetary policy (it closed at 7.67% on Monday). Post monetary policy, the yield closed trading at 7.72 %. Equity: BSE sensex was trading at 18024.08 before monetary policy. It increased post monetary policy and reached a high of 18150 levels. It then declined and closed at 18077.61.

Forex: The rupee trading at 46.67 per US dollar before monetary policy. Following the interest rate hike, it appreciated and closed at Rs. 46.68 per dollar. Other Important Developments Till now, RBI has been meeting once in a quarter to review the monetary policy. However, market participants have been suggesting more frequent reviews as the changes in macroeconomic outlook are rapid. The central bank has also been acting in interim. Therefore, RBI has decided to conduct mid-quarter reviews between the two policy meetings. The quarterly reviews will be held in June, September, December and March. The actions in these reviews will be released in a press release form. The next quarterly review will be held on September 16, 2010. As the systemic liquidity scenario is changing there is a need to review the current system of liquidity operations. For this, RBI has set up a Working Group to review the current operating procedure of monetary policy of the Reserve Bank, including the LAF. Disclaimer Clause This report is for customer information only and does not constitute investment advice or an offer to purchase or subscribe for any investment. This document is not intended to provide professional advice and should not be relied upon in that regard. Persons accessing this document are advised to obtain appropriate professional advice where necessary. This document is not directed to or intended for display, downloading, printing, reproducing or for distribution to or use by any person or entity who is a citizen or resident or located in any locality, state, country or other jurisdiction where such distribution, publication, reproduction, availability or use would be contrary to law or regulation or would subject The Dhanalakshmi Bank Limited or its associates or group companies to any registration or licensing requirement within such jurisdiction. If this document is inadvertently sent or has reached any individual in such country, the same may be ignored and brought to the attention of the sender. This document may not be reproduced, distributed or published for any purpose without prior written approval of The Dhanalakshmi Bank Limited.