I have tried to analyse RBI’s monetary policy announced today. Here it goes:
In its annual monetary policy review for 2010-11, RBI increased its policy rates.
- Repo rate and Reverse repo rate increased by 25 bps to 5.25% and 3.75% respectively, with immediate effect. Impact: Repo is the rate at which banks borrow from RBI and Reverse Repo is the rate at which banks deploy their surplus funds with RBI. Both these rates are used by financial system for overnight lending and borrowing purposes. An increase in these policy rates imply borrowing and lending costs for banks would increase and this should 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. The move was in line with market expectations
- Cash reserve ratio (CRR) increased by 25 bps to 6.00%, to apply from fortnight beginning from 24 April 2010. Impact: When banks raise demand and time deposits, they are required to keep a certain percent with RBI. This percent is called CRR. An increase in CRR implies banks would be required to keep higher percentage of fresh deposits with RBI. This will lead to lower liquidity in the system. Higher liquidity leads to asset price inflation and also leads to build up of inflationary expectations.Before the policy, market participants were divided over CRR. Some felt CRR should not be raised as liquidity would be needed to manage the government borrowing program, 3-G auctions and credit growth. Others felt CRR should be increased to check excess liquidity into the system which was feeding into asset price inflation and general inflationary expectations. Some in the second group even advocated a 50 bps hike in CRR.
By increasing the rate by 25 bps, RBI has signalled that though it wants to tighten liquidity it also wants to keep ample liquidity to meet the outflows. Governor’s statement added that in 2010-11, despite lower budgeted borrowings, fresh issuance will be around Rs 342300 cr compared to Rs 251000 cr last year.
RBI’s Domestic Outlook for 2010-11
|Table 1: RBI’s Indicative Projections (All Fig In %, YoY)|
|2009-10 targets (Jan 10 Policy)||2009-10
|2010-11 targets (Apr 10 Policy)|
|GDP||7.5||Expected at 7.2 by CSO||8 with an upward bias|
|Inflation (based on WPI, for March end)||8.5||9.9||5.5|
|Money Supply (March end)||16.5||17.3||17|
|Credit (March end)||16||17||20|
|Deposit (March end)||17||17.1||18|
- Growth: RBI revised its growth forecast upwards for 2010-11 at 8% with an upward bias compared to 2009-10 figure of 7.5%. It said “Indian economy is firmly on the recovery path.” RBI’s business outlook survey shows corporates are optimistic over the business environment. Growth in industrial sector and services has picked up in second half of 2009-10 and is expected to continue. The exports and import sector has also registered a strong growth. It is important to note that RBI has placed the growth under the assumption of a normal monsoon. India could have achieved a near 8% growth in 2009-10 itself, if monsoons were better. Table 2 looks at growth forecasts of Indian economy for 2010-11 by various agencies.
|Table 2:Projections of GDP Growth by various agencies for 2010-11 (in %, YoY)|
|RBI||7.5 with an upward bias||8 with an upward bias|
|PM’s Economic Advisory Council||7.2||8.2|
|Ministry of Finance||7.2||8.5 (+/- 0.25)|
|Asian Development Bank||7.2||8.2|
|RBI’s Survey of Professional Forecasters||7.2||8.5|
- Inflation: RBI’s inflation projection for March – 11 is at 5.5% compared to FY March-10 estimate of 8.5% with an upward bias (the final figure was at 9.9%). RBI said inflation is no longer driven by supply side factors alone. First WPI non-food manufactured products (weight: 52.2 per cent) inflation, increased sharply from (-) 0.4%in November 2009, to 4.7% in March 2010. Fuel price inflation also surged from (-) 0.7 per cent in November 2009 to 12.7% in March 2010. Further, contribution of non-food items to overall WPI inflation, which was negative at (-) 0.4% in November 2009 rose sharply to 53.3% by March 2010. So, overall demand pressures on inflation are also beginning to show signs. These movements were visible in March 2010 itself, pushing RBI to increase rates before the official policy in April 2010.
- Monetary Aggregates: RBI has increased the projections of all three monetary aggregates for 2010-11. These projections have been made consistent with higher expected growth in 2010-11. Higher growth will lead to more demand for credit. Then management of government borrowing program will remain a challenge as well. High growth coupled with the borrowing program will need higher financial resources. Therefore, projections for money supply, credit and deposit are raised to 17%, 20% and 18% respectively.However, higher growth in money supply would also lead to build up of higher inflation and inflationary expectations. In an interesting article in Mint, Renu Kohli said growth in M1 is greater than M3.
I did some research on the same. But before analysisng the numbers let us understand what M1 and M3 mean.
There are various measures to calculate money supply. Each measure can be classified by placing it along a spectrum between narrow and broad monetary aggregates. Narrow money includes most acceptable and liquid forms of payment like currency and bank demand deposits. Broad money includes narrow money and other kinds of bank deposits like time deposits, post office savings account etc.
These different types of money are typically classified as Ms. The number of Ms usually range from M0 (narrowest) to M3 (broadest) but which Ms are actually used depends on the system. There are four Ms in India:
- M1: Currency with the public + Demand Deposits + Other deposits with the RBI.
- M2: M1 + Savings deposits with Post office savings banks.
- M3: M1+ Time deposits with the banking system
- M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).
Growth in M3 is higher than M1 between April- November 2009. From Dec-2009 onwards, the growth rate in M1 is higher than M3. The difference in M1 and M3 comes from the growth rate in time and demand deposits. Growth in Time deposits is higher than demand deposits between April-November 2009. From December 2009, onwards growth in demand deposits picks up. This in turn reflects in differences in growth rate of M1 and M3. The growth rate in currency is volatile. It declines 15% in August 2009 and then again increases to 17.9% in December 2009. It then declines to 15.6% in March 2010. Hence, the difference between M1 and M3 comes from surge in growth of demand deposits and decline in growth of time deposits.
So, this just confirmed what Kohli said. She added this could be interpreted in two ways. First, spending on consumption and production is increasing as economy has recovered from recession. Second, it could be people are spending now as they expect higher inflation in future. Higher inflation in future could also lead to higher returns on assets and property in future, therefore people are preferring to spend now.
It will be interesting to watch trends in M1 and M3 from now on as well.
RBI also outlined downside risks with its projections:
- First, there is still substantial uncertainty about the pace and shape of global recovery
- Second, if the global recovery does gain momentum, commodity and energy prices, which have been on the rise during the last one year, may harden further. This could put upwards pressure on inflation
- Third, monsoon will continue to play a vital role both from domestic demand and inflation perspective.
- Fourth, policies in advanced economies are likely to remain highly expansionary. High liquidity in global markets coupled with higher growth in emerging economies foreign capital flows are expected to remain higher. This will put pressure on exchange rate policy. RBI usually does not comment on its exchange rate policy. As the economic situation is exceptional, RBI also commented on India’s exchange rate policy.
Our exchange rate policy is not guided by a fixed or pre-announced target or band. Our policy has been to retain the flexibility to intervene in the market to manage excessive volatility and disruptions to the macroeconomic situation. Recent experience has underscored the issue of large and often volatile capital flows influencing exchange rate movements against the grain of economic fundamentals and current account balances. There is, therefore, a need to be vigilant against the build-up of sharp and volatile exchange rate movements and its potentially harmful impact on the real economy.
The policy stance remains unchanged from January 2010 policy.
|Table 3: Comparing RBI’s Policy Stance|
|October 2009 Policy||January 2010 Policy||April 2010 Policy|
Summary: Given the economic outlook, policy ahead is going to remain challenging. There are many trade-offs RBI has to manage. It needs to manage high inflation without impacting the growth process. The recent inflation numbers show rising demand side pressures on inflation. The market participants are already looking at an increase of around 100-150 bps by March 2011 end. The higher interest rates would make it difficult to manage the government borrowing program and also invite more capital flows. High interest rates could also lead to higher lending costs for the corporate sector. The challenges are not limited to domestic factors alone. The concerns remain on future outlook of advanced economies which complicates the policy process further.
Other Development and Regulatory Policies
In its Annual (in April) and Mid-term review (in October) of monetary policy, RBI also covers developments and proposed policy changes in financial system.
Some of the developments announced in this policy are:
New Products/Changes in guidelines
- Currently, Interest rate futures contract is for 10 year security. RBI has proposed to introduce Interest rate futures for 2 year and 5 year maturities as well.
- RBI has permitted recognised stock exchanges to introduce plain vanilla currency options on spot US Dollar/Rupee exchange rate for residents
- Final guidelines for regulation of non- convertible debentures of maturity less than one year by end-June 2010
- RBI had proposed to introduce plain vanilla Credit Default Swaps in October 2009 policy. RBI would place a draft report on the same by end- July 2010
- Earlier, banks could hold infrastructure bonds in either held for trading or available for sale category. This was subject to mark to market requirements. However, most banks hold these bonds for a long period and are not traded. From now on, banks can classify such investments having a minimum maturity of seven years under held to maturity category. This should lead banks to buy higher amount of infrastructure bonds and push infrastructure activity.
- The activity in Commercial Papers and Certificates of deposit market is high but there is little transparency. FIMMDA has been asked to develop a reporting platform for Commercial Papers and Certificates of deposit.
Setting up New Banks
- Finance Minister, in his budget speech on February 26, 2010 announced that RBI was considering giving some additional banking licenses to private sector players. NBFCs could also be considered, if they meet the Reserve Bank’s eligibility criteria. In line with the above announcement, RBI has decided to prepare a discussion paper on the issues by end-July 2010 for wider comments and feedback.
- In 2004 seeing the financial health of urban cooperative banks, it was decided not to set up any new UCBs. Since then the performance of these banks has improved. It has been decided to set up a committee to study whether licences for opening new UCBS can be done.
- In February 2005, the Reserve Bank had released the ‘roadmap for presence of foreign banks in India’. The roadmap laid out a two-phase, gradualist approach to increase presence of foreign banks in India. The first phase was between the period March 2005 – March 2009, and the second phase after a review of the experience gained in the first phase. In the first phase, foreign banks wishing to establish presence in India for the first time could either choose to operate through branch presence or set up a 100% wholly-owned subsidiary (WOS), following the one-mode presence criterion. Foreign banks already operating in India were also allowed to convert their existing branches to WOS while following the one-mode presence criterion.However, because of the global crisis the second phase which was due in April 2009, could not be started. The global financial crisis has also thrown some lessons for policymakers. Drawing these lessons RBI would put up a discussion paper on the mode of presence of foreign banks through branch or WOS by September 2010.