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April 21, 2010

RBI ANNUAL MONETARY POLICY: 2010-11 RBI came out with its annual monetary policy for 2010-11 which was in line with market expectations. RBI hiked repo, reverse repo and CRR by 25 bps each. The policy rate hikes will be done with immediate effect while the CRR hike will be effective from April 24. The increase in CRR is expected to absorb about Rs 12500cr from the system. In the wake of the global economic crisis, the RBI pursued an accommodative monetary policy beginning mid-September 2008. This policy instilled confidence in market participants, mitigated the adverse impact of the global financial crisis on the economy, and ensured that the economy started recovering ahead of most other economies. H owever, strong signs of recovery in the economy and rising inflation, both consumer as well as asset price inflation, the RBI embarked on the first phase of exit from the expansionary monetary policy by restoring the statutory liquidity ratio (SLR) of scheduled commercial banks to its pre-crisis level in the Second Quarter Review of October 2009. The process was carried forward by the second phase of exit when the RBI announced a 75 bps increase in the CRR in the Third Quarter Review of January 2010. As inflation continued to increase and exceeded the RBI’s baseline projection of 8.5% for March 2010, RBI responded expeditiously with a mid-cycle increase of 25 bps each in the repo rate and the reverse repo rate on March 19, 2010. Key highlights of the RBI Annual Monetary Policy for 2010-11:

MONETARY MEASURES

1.-Bank Rate Unchanged at 6.0%.

2.-Repo Rate Hiked from 5.0% to 5.25% (with immediate effect).

3.-Reverse Repo Rate Hiked from 3.5% to 3.75% (with immediate effect).

4. Cash Reserve Ratio Hiked from 5.75% to 6.0% (effective from April 24). As a result of the hike in CRR, Rs. 12500cr (approx.) of excess liquidity will be Absorbed from the system.

5.-Statutory Liquidity Ratio Unchanged at 25%.

OUTLOOK AND PROJECTIONS

GDP Growth Projection

• RBI placed its GDP growth projection for 2010-11 at 8.0% with an upside bias under the assumption of a normal monsoon and good performance of the industrial and services sectors.

Inflation Projection

•••• Keeping in view domestic demand-supply balance and the global trend in commodity prices, the baseline projection for WPI inflation for end-March 2011 is Placed at 5.5%.

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Monetary Projection

•••• The projection of money supply growth for 2010-11 is placed at 17%.

•••• Consistent with this, aggregate deposits of Scheduled Commercial banks (SCBs) are projected to grow by 18%.

•••• The growth in non-food credit of SCBs is placed at 20%.

OTHER STANCES

•••• Introduction of a reporting platform for all secondary market transactions in Certificate of Deposits (CDs) and Corporate Papers (CPs)

•••• FIMMDA has been requested to start work on developing a platform for CDs and CPs Similar to its existing platform for corporate bonds.

•••• To allow banks to classify their investments in non-SLR bonds issued by companies Engaged in infrastructure activities and having a minimum residual maturity of seven Years under the held to maturity (HTM) category

•••• The much awaited paper on bank licenses for the private companies will be placed on RBI’s website by end-July 2010.

•••• By end of June, the bank proposes to prepare the draft for Credit Default Swaps (CDS) introduction. Around the same time, it will finalize OTC forex derivatives norms.

•••• In order to give a further thrust to infrastructure financing by banks, it is proposed that infrastructure loan accounts classified as sub-standard will attract a provisioning of 15% instead of the current prescription of 20%. To avail of this benefit of lower provisioning, banks should have in place an appropriate mechanism to escrow the cash flows and also have a clear and legal first claim on such cash flows.

The hike in policy rates and CRR is broadly in line with expectations. The wellbalanced measures taken by the RBI are aimed at controlling inflation and promoting sustainable growth. But it considers tempering of liquidity equally important. There are speculations of lending getting more expensive but the system still possesses a lot of liquidity and April-June quarter is a lean period for credit off-take and hence the interest rates should not move sharply in an upward trend. RBI has given indications to act on rates again if Inflation is not contained by the current rate hike. Cost of Consumer finance loans may rise marginally but it is not likely to be affected much as demand for consumer goods is very strong and may not be impacted by a 25 basis point hike in key policy rates. Central bank has remained cautious in increasing rates to ensure that the growth is not Hampered while checking inflationary pressures.

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Kirang Gandhi

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Impact on Debt Markets

The initial reaction of bond markets to the monetary policy was that of positive relief. Benchmark 10 year G-Sec yields fell from 8.08% on April 19, 2010 to 7.98% on April 20, 2010 as the rate hikes were broadly in line with expectations. Moreover, RBI’s inflation estimates of 5.5% for March 2011, though a tad too optimistic, were taken as a positive. The stance of RBI towards keeping liquidity comfortable in the near term to ensure a smooth passage of the government borrowing plan also helped spark the relief rally. H owever, going ahead, yield movements will be guided more by supply side pressures in the form of a huge government borrowing plan and by the movement in oil prices as they threaten to widen the fiscal deficit. On the whole, we expect 10 year G-Sec yields to hover near the 8% mark in the near term. Short term yields are likely to see upward pressure and might rise to 7% levels from the 6.5-6.6% levels at present. Call money rates are likely to continue hovering near to the lower end of the LAF band i.e. 3.75% as liquidity continues to remain comfortable in the system even after the hikes.

Impact on Equity Markets

The rate hike of 25 bps across CRR, Repo and Reverse repo is in line with expectations and has been welcomed by the equity markets. This is clearly visible in the way the broader equity indices moved just after the announcement of the policy. While, the rate hike definitely increases the cost of funds for banks the same is unlikely to be passed on to consumers immediately, given the weak credit growth and ample liquidity in the banking system. Also, RBI’s move to allow banks’ to classify their investments in Non-SLR bonds issued by infrastructure companies with residual maturity period of 7 years in H TM category and the change in provisioning norms relating to sub-standard infrastructure loan accounts, is positive for infrastructure companies as well as banks. Post the credit policy the markets are likely to see the formation of two camps of investors – one which believes that RBI is behind the curve in terms of rate hikes and will not be able to control inflation (this camp will tend to be bearish on markets) and the other which believes that RBI is in control of the situation and will be able to manage growth and inflation effectively (this camp is likely to be bullish). All other things remaining constant, the future direction of markets is likely to be determined by which camp outweighs the other in terms of number of participants.