RBI first quarter 2010-11 review of monetary policy - update

In its first quarter review of monetary policy  for 2010-11, RBI increased its policy rates with immediate effect. (See Policy doc here and Governor’s press statement here)

• Repo rate increased by 25 bps to 5.75%
• Reverse repo rate increased by 50 bps to 4.50%.
• Cash Reserve ratio maintained at 6.00%. CRR was kept unchanged because of persistent deficit liquidity situation

Before I discuss the monetary policy outlook let me point to another great RBI initiative under D. Subbarao.

RBI now will be meeting 8 times in an year instead of the current practice of 4 quarterly meetings. The new 4 meetings will be mid-quarter reviews and will be held roughly between 2 quarterly 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.

Market participants have been suggesting this for a while.More frequent meetings are important and as macroeconomic outlook is changing and evolving very rapidly. Moreover, RBI is anyways taking actions before actual monetary policy recently. So, it is better to make this system official and increase transparency. As RBI says, it will take the surprise element from off-cycle monetary policy actions.

Another great step by RBI…

Now back to monetary policy discussion. Going to be a long post…..

Impact of rate hikes

An increase in repo and reverse repo rates imply borrowing and lending costs for banks will increase. This should ideally lead to overall increase in interest rates like credit, deposit etc. The higher interest rates will in turn lead to lower demand and thereby lower inflation. This is called monetary transmission process. However, this process may not work perfectly and pose further problems for a central bank. Like RBI lowered its policy rates in this crisis but banks did not lower their credit rates (for specific reasons). Likewise, central banks like Fed etc lowered their rates to near zero but economic activity failed to pick up.

Even now, we do not know whether these rate hikes will lead to higher deposit or lending rates. Most bank chairmen have said that they will be little impact of policy rate hike on lending and deposit rates. If we see market reactions to monetary policy (at the time of writing the report), we do see hardening of rates and appreciation in Rupee.  Though equity markets have risen:

•  G-sec:  The 10-year yield was trading at 7.67% before monetary policy (it closed at 7.67% on Monday). The yield hardened to touch 7.71 % after the monetary policy. People in markets say the rise in yields would be initial reacrtion and then yields will again come down. Let’s see what happens..
• Equity: BSE- Sensex was trading at 18024.08 before monetary policy. It increased and closed at 18077 levels for the day
• Forex: Indian Rupee trading at 46.84 per US Dollar before monetary policy. Following the interest rate hike, it appreciated to 46.66 per USD.

Narrowing of the corridor
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 rate.

The corridor between repo and reverse repo serves as the area under which money market rates should be trading. So if repo rate is 5.75% and reverse repo rate is 4.50%, money market rates i.e. call rate, CBLO rate, NSE –Mibor etc should be trading between 4.50% and 5.75%. Why should this be? It is because RBI rates act as the benchmark rates as RBI is considered as the safest counterparty. Ideally, banks will be borrowing/lending from other private sector counterparties at higher rates.  So say, there is a bank which has surplus money and wants to lend it. It will either place it with RBI at reverse repo rate of 4.50% or lend it to deficit private sector counterparty but demand higher rates, charging for a higher counterparty risk. So, in this way corridor between Repo and Reverse Repo rate serves as a path for money market rates as well. Though again there are many times when money market rates trade over or below the corridor.

The corridor is widened in times of high uncertainty in economy and financial markets. As money market rates turn volatile in such a situation, RBI widens to the corridor so that money market rates do not trade outside the corridor. The corridor remained at 100 bps till October 2006. After October 2006, as inflation increased there were signs of overheating of economy. RBI widened the corridor significantly from 100 bps to 300 bps In July 2008. Then as the global crisis hit Indian economy 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 panic in markets. 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 but it has been increasing both by same amount so corridor has remained at 150 bps.

As economy and markets improved, there were talks amidst market participants to lower the corridor further to 100 bps. RBI supposedly has looked at this and the corridor now stands at 125 bps. But it is puzzling as global uncertainty still continues. RBI itself says global risks have again risen and trajectory is unclear. Given such a scenario, I don’t know why corridor has been narrowed.

As the systemic liquidity scenario has become dynamic, 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.

RBI’s Domestic Outlook for 2010-11

Table 1: RBI’s Indicative Projections for 2010-11 (All Fig In %, YoY)
	Apr 10 Policy	Jul 10 Policy
GDP	8 with an upward bias	8.5
Inflation (based on WPI, for March end)	5.5	6
Money Supply (March end)	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

Growth:
RBI revised its growth forecast upwards for 2010-11 at 8.5% from 8% with an upward bias given in Apr-10 policy.  As said in my previous post, this was on expected lines as well.

RBI Governors’ statement on monetary policy said that growth prospects have improved since last meeting in April 2010. There has been an overall increase in all sectors. Agriculture production is expected to be better than last year because of good monsoon rains. The industrial sector continues to be robust as IIP trends indicate. Corporate performance has been good as well with pickup in sales and profitability. The statement added that “Investment intentions are translating into action across sectors”. Increase in exports and widening of current account deficit also suggests strong growth momentum.  

Given all this, RBI raised its growth projections upwards to 8.5%. RBI’s projections are in line with other agency forecasts (Table 2). We have been covering these outlooks in our economic weekly editions. IMF growth is for calendar 2010 and is based on GDP at market prices where as others are based on GDP at factor cost.

Table 2:Projections of GDP Growth by various agencies for 2010-11 (in %, YoY)
	Earlier Projection		Latest Projection
RBI	8 with an upward bias	Apr-10	8.5	Jul-10
PM’s Economic Advisory Council	8.2	Feb-10	8.5	Jul-10
Ministry of Finance	8.5 (+/- 0.25)	Feb-10	–	Not updated
IMF (for calendar year 2010)	8.8	Apr-10	9.4	Jul-10
Asian Development Bank	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

Inflation:
RBI’s inflation projection for March – 11 has also been raised upwards from 5.5% to 6%. This was again on expected lines.  

Inflation has been a concern for RBI for more than an-year. Inflation has moved from food prices driven/supply side inflation to manufactured prices/demand driv

Since April 2010 policy, there has been an increase in prices of many administered/ regulated items such as petroleum products, iron ore and electricity. 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 on inflation will be about one percentage point on WPI inflation, with second round effects coming through in the months ahead. And if oil prices rise further, higher impact could be seen ahead. Then even minimum support prices have been increased which will impact inflation. Overall inflation continues to remain a major concern for RBI. Though, inflationary expectations have not increased as per RBI’s quarterly inflation expectation survey conducted in June 2010.

RBI further said inflation outlook will depend on three factors:

• Monsoon rains
• Global energy and commodity prices.
• Domestic growth outlook. If it keeps improving, it could lead to further demand-side pressures on inflation.

Monetary Aggregates

RBI has kept the projections for monetary aggregates unchanged. Currently growth rate of credit is higher than projections and growth rates of deposits and money supply is lower. But still RBI believes monetary aggregates will evolve along the projected trajectory given in April 2010 policy.  Surprisingly, RBI has not given any projection for deposits. 

Though it explains a growing mystery. How credit is growing despite deposits not picking up? To finance higher credit banks have unwound their mutual fund investments and borrwoing via repo window. Now, first option is ok but second is dangerous. Banks should not be giving long term credit using short term borrowing. This has been the critical lesson from this crisis. My guess is this would be quite small otherwise RBI would have raised concerns.

Risk Factors

There are several risk factors associated with above projections. The most important risk is the emerging global outlook. It is still highly uncertain after nearly three years of crisis. The uncertainty has again risen. 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 Indian economy outlook like it happened lost Lehman crisis. Growth dipped from 9% plus pre-crisis to 6.7% in 2008-09.
• Exports: A widespread slowdown in global trade will impact exports. There are already concerns that exports might slowdown because of ongoing European crisis.
• Capital flows: We could see a potential slowdown in capital inflows. Even if both exports and imports slowdown, current account deficit is expected to remain, as imports have grown faster than exports. This could lead to problem of managing the rising import bill. It may also constrain domestic investment, which is critical to achieving and sustaining high growth rates.

  Though, 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. Large capital inflows above the absorptive capacity of the economy then pose 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

Given above analysis, policy stance is pretty clear. It is to manage inflationary expectations keeping a close watch on the emerging global economic scenario. As liquidity situation remains in deficit and liquidity is critical for monetary transmission, managing it actively will also remain a policy task.

It remains broadly unchanged from previous monetary policy stances:

• 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.

Summary

RBI Monetary Policy review was broadly in line with expectations. Barring a higher than expected increase in reverse repo rate most of the actions were anticipated well in advance. The policy challenges will continue to remain. Though Indian economy is expected to grow but because of continued global uncertainty, path remains unclear. Balancing the global outlook with Indian outlook will remain the key. As RBI wants to lower inflation to preferred range of 4-4.5%, more rate hikes will come. In RBI’s words, it will also help normalise policy rates in line with expected growth and inflation.

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