June 3, 2014 Second Bi-Monthly Monetary Policy Review RBI kept key policy rates unchanged in line with consensus expectations. RBI reduced statutory liquidity ratio (SLR) by 50 bps to 22.50% with effect from fortnight beginning June 14, 2014 to allow banks to expand credit to non-government sector. It reduced the liquidity provided under the export credit refinance (ECR) facility from 50% of eligible export credit outstanding to 32% and this has been compensated by introducing a special term repo facility of 0.25% of Net Demand and Time Liabilities (NDTL) with immediate effect. It will continue to provide liquidity under 7-day and 14-day term repos of up to 0.75% of NDTL of the banking system Consumer Price Index (CPI) Inflation trajectory continued to be targeted at 8.0% by January 2015 & 6.0% by January 2016. FY15 Gross Domestic Product (GDP) growth is projected around at around 5.5% from 4.7% in FY14. RBI has softened its tone against inflation in anticipation of fall in its future trajectory. The Governor has depicted faith on the new government to act on supply side bottlenecks to lower food inflation and continue on the path of fiscal consolidation. The tone of the policy is neutral with dovish tone. At the last policy meeting the RBI said that it would look through the base effect-driven fall in CPI inflation in H2, but has now mentioned the possibility of rate cuts if disinflation (adjusted for base effects) is faster than anticipated. We expect RBI to ease rates as early as Q3 FY 15, on sharp fall of CPI Inflation trajectory. RBI Rate Actions - 1
Key Policy Highlights: CPI Inflation: RBI is focused on keeping the economy on a disinflationary glide path that is intended to hit 8% CPI inflation by January 2015 and 6% by January 2016. At the current juncture, it felt appropriate to hold the policy rate, while allowing the recent rate increases to work their way through the economy. Furthermore, if inflation continues along the intended glide path, further policy tightening in the near term is not anticipated at this juncture. RBI acknowledged the recent rise in headline CPI number on the back of sharp increase in food prices but attributed seasonal factors for the rise of food inflation. RBI also acknowledged the fact that CORE CPI is edging down. RBI underplayed the biggest threat to retail inflation owing to spike in food prices in the event of below normal monsoon by taking comfort from likely stronger measures by the government to mitigate supply side bottlenecks. This could be viewed as a drastic switch of stance as any supply side shock in food inflation will not be easy to tame and can send CPI projected trajectory for a toss. If the economy stays on this course, further policy tightening will not be warranted. On the other hand, if disinflation, adjusting for base effects, is faster than currently anticipated, it will provide headroom for an easing of the policy stance. Economic Growth: Indian economy is projected to grow at 5.5% in FY15 from 4.7% in FY14 based on following assumptions: The outlook for the agricultural sector is contingent upon the timely arrival and spread of the monsoon. Easing of domestic supply bottlenecks and progress in the implementation of stalled projects should brighten the outlook for both manufacturing and services. The resumption of export growth is a positive development and as world trade gathers momentum, the prospects for exports should improve further. Liquidity Measures: Gradual Shift from sector-specific refinance facility to term repo facility In pursuance of the Dr. Urjit R. Patel Committee s recommendation to move away from sector-specific refinance towards a more generalized provision of system liquidity (without preferential access to any particular sector or entity), the RBI has decided to limit access to export credit refinance while compensating fully with a commensurate expansion of the market s access to liquidity through a special term repo facility (equivalent to 0.25% of NDTL). This should improve access to liquidity from the Reserve Bank for the system as a whole without the procedural formalities relating to documentary evidence, authorization and verification associated with the ECR. - 2
Cut in Statutory Liquidity Ratio (SLR) ratio: RBI has cut SLR ratio by 50 bps to 22.5% of NDTL to give banks more freedom to expand credit to the non-government sector - keeping in mind, significant on-going financing needs of the Government. Any further change in SLR ratio will be dependent on the likely path of fiscal consolidation o Right now, SLR adjusted for Liquidity Adjustment Facility (LAF) is around 27% (higher than the mandatory requirement) given the sluggish economic growth and subdued industrial activity. o However, as the economy recovers, investment demand and the need for credit will pick up. To the extent that this contributes eventually to supply, it is important that banks have the room to finance it. Key Take Away: The tone of the policy is neutral with dovish tone. At the last policy meeting the RBI said that it would look through the base effect-driven fall in CPI inflation in H2, but has now mentioned the possibility of rate cuts if disinflation (adjusted for base effects) is faster than anticipated. We expect RBI to ease rates as early as Q3 FY 15, on sharp fall of CPI Inflation trajectory. Going forward, the RBI has decided to reduce further market s dependence on sector-specific refinance like exports credit refinance and move towards more generalised provision of system liquidity without preferential access to any particular sector or entity. RBI has fully compensated reduction in export credit refinance by increasing access to liquidity through special term repo facility (around Rs. 20,000 cr). This should improve the transmission of policy impulses across the interest rate spectrum and engender efficiency in cash/treasury management. Reduction in SLR ratio by 50 bps is a preemptive move since currently SLR ratio adjusted for LAF is higher than the mandatory requirement given sluggish economic growth and subdued credit pick-up. The cut in SLR would provide liquidity to the banks to fund the non-government sector as the economy is expected the pick-up with new government in the place and economy expected to pick-up on policy initiatives. Market Outlook: 1. Government Securities: The policy guidance played a major support for G-sec helping investors to shrug the negative in the form of SLR cut. G-sec has consolidated gains and the current upside in yields might be capped at 8.70% while the yields can significantly drift lower from present levels, CPI release on June 12 will influence the trajectory although the play is valid only till the release of final budget of FY15 that can be expected to be rolled out in early July. G-Secs will spearhead any downward move in rates. Current demand supply dynamics are well balanced, and expected fiscal consolidation will improve these dynamics. FII participation will be primarily concentrated in G-Secs and higher credit quality corporate assets, thus creating additional demand for G-Secs. - 3
We expect the 10 year benchmark yields to move down sharply over the next 06-12 months, from the current range of 8.60%-8.65%. 2. Yields Shorter end of the curve: With the stable government at the centre, we have seen robust FII flows in the market, thus creating further demand for Indian GSecs and corporate bonds. Also with RBIs continuous injection of liquidity through FX sterilisation, term Repos and OMOs (only for permanent liquidity injection), we expect shorter end of the curve to be well supported at the current levels. Longer end of the curve: CPI Inflation, a key monetary policy variable, has peaked out. Core CPI Inflation (excluding food &fuel) may hit 7% in the coming months. In a weak growth environment, and with stability on the external front, RBI will get more legroom for policy easing. Hence we expect longer end yields to decline over next 06 to 12 months. 3. Liquidity : RBIs main intention is to keep liquidity adequate into the system and it has supported it by continuous Term Repos or OMOs ( only for permanent liquidity injection ) whenever needed. Also with favorable election results, we have seen robust FII flows in the market, thus further improving domestic liquidity. RBI will continue to provide liquidity into the system and overnight rate will hover around the Repo rate going forward. With RBI committed at micro-managing liquidity major jitters could be ruled out. However, outflow in the form of indirect and advance taxes would exert some pressure on liquidity and the special term repo compensating the pruned export refinance facility would mean temporary upside for overnight rates amid liquidity tightness scenario. 4. Shape of the Yield Curve : The current corporate bond yield curve is flat with AAA 1yr assets at 8.95% and 10yr assets at 9.20%. Expected improvement in overall liquidity conditions from robust portfolios flows and improving Fiscal and Current Account dynamics. RBI will get more comfortable with adequate system liquidity as the inflation pressures start receding. We expect the curve to steepen meaningfully over the next 06 to 12 months. Common Data Source: RBI,CMIE,Bloomberg - 4
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