The Reserve Bank of India (RBI) will release the Q1 review of the monetary policy and macro-economy today (July 27, 2010) at 11.30 AM . Market participants expect RBI to increase both the repo and reverse repo rates by 25 basis points (bps) each to 5.75% and 4.25% respectively.
The markets expect RBI to maintain the cash reserve ratio (CRR) at 6%, given the persistent deficit liquidity conditions.
RBI has been increasing interest rates for three reasons:
1. Inflation and inflationary expectations are building up;
2. Growth numbers (such as IIP and GDP) have been robust;
3. To normalise interest rates. RBI lowered its policy rates aggressively during the global financial crisis two years ago. As the conditions steadily improved, RBI began to raise interest rates. Real interest rates (nominal rate minus inflation) are still negative, implying that more rate hikes may be needed. But, as the global economy still faces huge uncertainties, RBI has adopted a gradual pace towards normalising interest rates.
Since July 2 2010 rate increases, then there have been two main data releases – WPI monthly inflation for Jun 2010 and IIP for May 2010. Both were lower than market expectations, yet fairly high.
Again, the challenge for RBI will be to lower high inflation and inflationary expectations, amid global uncertainty. Let us review the conditions against which RBI decides to tweak or not tweak its monetary policy.
Indian Economy Outlook and Developments
- Growth: IMF and PM’s EAC both have revised growth outlook upwards for India. IMF in its July 2010 World Economic Outlook update put India growth for 2010 at 9.4%, higher than 8.8% pegged in April. EAC in its 2010-11 outlook report has revised growth outlook for 2010-11 from 8.2% (in Feb-10 outlook report) to 8.5%. So, growth outlook just gets better with each outlook. There are expectations that RBI might also revised the growth outlook upwards. In April 2010 policy, it put growth for 2010-11 as 8% with an upward bias.
- IIP for May 2010 stood at 11.5% — significantly lower than market expectations of 16%. Market players now expect IIP growth to slow down as companies take a break from the record production levels. The index levels still remain high.
- WPI monthly inflation for Jun 2010 showed trends continue to surge and was at 10.55% in June 2010. It was also lower than market expectations of around 10.8%. The inflation figure continues to be revised upwards. For April 2010, it was revised upwards from 9.59% to 11.23% and the March 2010 numbers were revised upwards from 9.9% to 11.04%. Chances are that the June numbers too will be revised upwards to around 11.5%. Hence, overall inflation is much higher than what the provisional figures show. Core inflation has surged from -0.8% in November 2009 to 7.3% in May 2010. Core inflation itself is higher than RBI’s projected March-end 2010 inflation rate of 5.5%.
CPI inflation has declined, but still remains in the 13.6-14.5% range. Moreover, the decline is on account of the base effect, as indices continue to rise. Overall, significant inflation pressures remain.
However, there is a positive news on the monsoon front. Rainfall, till now, has been better than last year. The cumulative seasonal rainfall for the whole country up to July 21, 2010, has so far been 14% below the long period average (LPA). Of the 36 meteorological subdivisions, rainfall has been excess in over 50, normal in over 21 and deficient in 10. Although it has been below normal for the whole country, areas such as Punjab have got excess rainfall. Hence, expectations are that supply-side pressures on food and food prices will be lower.
- Liquidity Situation: High growth, coupled with high inflation, is a strong factor for RBI to hike interest rates. There were two points that made the RBI move uncertain – liquidity position and global economic outlook (explained later). Money markets have been facing deficit liquidity since June. The situation worsened because of money outflows due to payments for the 3G and broadband wireless access spectrum auctions and tax outflows. Since then, the deficit in liquidity has hovered around Rs 50,000-70,000 crore. Money market rates have moved up because of this. Hence, markets were not sure whether RBI would increase its policy rates.
The deficit was expected to be temporary and liquidity was expected to come back in the system from mid-July 2010 onwards. However, the deficit in liquidity persists.
RBI extended the second liquidity adjustment facility till July 30, 2010. But as the liquidity deficit continues, it is expected that the second LAF facility will be further extended. There is an interesting point made by some market participants: why should RBI increase the repo rate under this deficit liquidity situation and make it further costlier for banks? They suggest that RBI should only be increasing its reverse repo rate and not tax the banking system further.
- Monetary aggregates: Growth in non-food credit has surged and touched 22.1% in the fortnight ended July 2, 2010. This is much higher than RBI’s projected growth of 20% for March 2011. Much of this growth is because of payments made for 3G and Wireless spectrum auctions.
On the other hand bank deposits have grown by 16%, lower than the growth of credit. That figure is also lower than RBI projections of 18%. Time deposits form around 87% of the total deposits and have been growing at around 13.6%. As bank deposits form the bulk of money supply (M3), it is also assumed to be growing at around 16%.
||RBI Projection for March 2011 end (YoY, in %)
||Growth as on 2 Jul 2010 (YoY, in %)
Global Economy Outlook and Developments
The global economy is at a critical juncture. The European Union released the results of a stress test conducted on 91 select banks. Only seven banks failed the test – five in Spain and one each in Germany and Greece. As the results were released on late Friday, analysis and comments are still pouring in.
European policymakers say the tests prove that things are not as bad with European banks as it was made out to be. So, markets should improve now and not be so pessimistic over Europe. However, some have called the stress tests ‘soft’ and even alleged that there is a lot of window dressing of balance sheets. Hence, a more refined analysis will be made only after markets open on Monday.
Economic data from the US have again worsened since June. US Fed chairman Ben Bernanke recently termed the US economic outlook as highly uncertain. Some economies — such as those of the US, UK and the Euro area countries — are still hurting and an increase in interest rates looks like a remote possibility. However, growth has picked up in some economies and their central banks raised rates recently. New Zealand, Canada, Sweden and Chile are examples.
The question being debated currently is whether economies should impose fiscal austerity plans or not. Proponents say, given the high debt levels austerity will infuse confidence in markets. However, naysayers point that there is huge stress in economies and fiscal austerity will backfire, given the similar experiences in Japan and during the Great Depression.
Given this background, RBI is expected to continue to increase its interest rates. But with global uncertainty still very high and economies recovering mainly because of stimulus packages, the outlook is still hazy.