1QFY2014 Monetary Policy Review | Banking

July 30, 2013

1QFY2014 Monetary Policy Review

Constrained by impossible trinity, RBI maintains rates
Policy Measures

Vaibhav Agrawal
022 3935 7800 Ext: 6808 vaibhav.agrawal@angelbroking.com

Bhupali Gursale
022-3935 7800 Ext: 6820 bhupali.gursale@angelbroking.com

The Reserve Bank of India (RBI) in its First Quarter Review of the monetary policy maintained status quo on policy rates, in line with our and market expectations. The Repo Rate stands unchanged at 7.25%, Reverse Repo Rate at 6.25% and the Cash Reserve Ratio remains unchanged at 4.00% of banks NDTL. After cutting rates thrice in 2013, the RBI maintained status quo on rates for the second time since June in order to address macro-stability concerns owing to the sharp INR depreciation. The policy came in the backdrop of recent hikes by the RBI in the Marginal Standing Facility (MSF) Rate and Bank Rate by 200bp to tackle exchange rate volatility and they continue to remain at 10.25%. The RBI has revised its real GDP growth projection for FY2014 lower to 5.5% from the earlier estimate of 5.7%. The trajectory for WPI inflation is expected to reach 5.0% by end-March 2014 on account of soft global commodity prices, good monsoon and sluggish demand scenario. The RBI has amply indicated that given the growth-inflation dynamics, it would in normal circumstances have supported growth. However to revert to that stance, stability in currency remains key. We believe that in the near-term, coupled with the growth-inflation scenario, developments on the CAD front and capital flows in the economy would continue determining the policy stance.

Policy constrained by the impossible trinity

In its guidance on the monetary policy stance, the RBI concurs that it is constrained by the impossible trinity trilemma. In the current context, with the policy-makers not keen on letting the exchange rate be dictated purely by market forces, it is monetary independence that RBI has acknowledged to sacrifice to an extent. Simply put, the RBI has indicated that sluggish demand and growth conditions and moderating inflation would have warranted a more growth-supportive stance. However, the exchange rate volatility amidst a high current account deficit (CAD) and risk of continued capital outflows due to the U.S Feds anticipated withdrawal of QE have compelled it to increase short-term rates to elevated levels. The RBI has tightened monetary conditions particularly at the short-end since July 15, 2013 in order to contain exchange rate volatility. The policy had some dovish remarks regarding their eventual roll-back, possibly to manage medium-term growth expectations. But the calibrated withdrawal is conditional on forex stability, which itself could be challenging in the near-term due to global and domestic factors unless there are sharper measures from the government to address imports and exports. We believe that with these measures likely to continue over the next 1-2 months, we might see transmission of higher-than-anticipated interest rates into broader segments.

Please refer to important disclosures at the end of this report

Monetary Policy Statement FY2014

Monetary tightening through stealth

The minutes of the Federal Reserve in its May policy meeting indicated at an improving economy and strengthening labor market conditions. This fuelled speculation of an earlier-than-expected exit from the Feds QE3 ie tapering off of the USD85bn per month bond purchase program. Consequently, bond yields in the US have started rising and emerging market (EM) economies have witnessed a sell-off in their capital markets. The USD has strengthened against major currencies levying considerable pressure on emerging markets currencies (including the INR). The INR remains vulnerable to external shocks owing to Indias elevated current account deficit and dependence on foreign capital flows for its financing. Taking cues from the Feds policy, since June 2013 FIIs have turned net sellers in the debt and equity markets with outflows amounting to USD7.4bn in debt and USD2.8bn in equities. Consequently, the currency has depreciated by almost 10% since May 2013. The RBI has maintained caution on INR depreciation on account of the risks to the twin-deficits CAD and fiscal deficit, reversal of capital flows and imported inflationary pressures.

Exhibit 1: Currency depreciation vis-a-vis USD

(- depreciation/+ appreciation) 10 5 0 -5 -10 -15 Malaysia Russia Japan Brazil Indonesia Thailand S. Korea India Turkey Euro area China UK 2012 2013 YTD

Exhibit 2: FII investment in debt and equity markets

(USDbn) 6.0 4.0 2.0 (2.0) (4.0) (6.0) Feb-12 Feb-13 Jun-12 May-12 May-13 Sep-11 Mar-12 Aug-12 Nov-12 Mar-13 Oct-12 Dec-12 Jun-13 Jul-12 Jul-12 Apr-12 Sep-12 Apr-13 Jan-12 Jan-13 Jul-13 May-13 FII net equity inflows FII net debt inflows

Source: Bloomberg, Angel Research

Source: Bloomberg, Angel Research

Exhibit 3: CAD has widened considerably in past 3 years

(USD bn) (10.0) (20.0) (30.0) (40.0) (50.0) (60.0) (70.0) (80.0) (90.0) (100.0) FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 CAB (USD bn) CAB as % of GDP (RHS) (% of GDP) (1.0) (2.0) (3.0) (4.0) (5.0) (6.0)

Exhibit 4: Declining import cover of forex reserves

(Months) 20.0 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 May-03 Sep-01 Mar-04 Jan-00 Jan-05 Nov-00 Jul-02 Import cover

May-08

Sep-06

Mar-09

Nov-05

Jan-10

Source: RBI, Angel Research

Source: RBI, Angel Research

July 30, 2013

Nov-10

Jul-07

Monetary Policy Statement FY2014

Measures taken by the RBI: Therefore, to tackle the bout of speculation on the INR and attract debt flows, the RBI has taken some strong measures in recent weeks with a view of constraining liquidity in the system. The RBIs recent measures to contain exchange rate volatility can be summarized as below: 1. On July 15, it hiked the penal rate at which banks access additional funds from the RBI. Consequently, the MSF and bank rate stand adjusted at 10.25%, 300bp above the repo rate. The RBI also capped borrowing of banks from the LAF window (at the softer rate of 7.25%) to 1% of the systems NDTL ie `75,000cr per day. But this limit was subsequently revised on July 23, 2013 to a more stringent 0.5% of each individual banks NDTL. Through these measures, the RBI has effectively curtailed borrowings from the LAF window and raised the excess borrowing cost for banks to 10.25% under the emergency lending facility. In addition, banks are expected to maintain a minimum daily Cash Reserve Ratio (CRR) balance of 99% of the prescribed requirement, up from a minimum of 70% mandated earlier on a daily basis. This step is akin to a hike in the CRR. The RBI also announced open market sale of government securities to the tune of `12,000cr (but it raised just `2,532cr). RBI had also prohibited banks from proprietary trading of currency futures and exchange traded currency options on exchanges while SEBI doubled the margin requirement for currency derivatives to reduce speculative positions.

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Following the announcement of these measures, the bond yields have hardened by nearly 150bp on the short-end. With higher nominal rates and decelerating inflation, the real interest rate is also on a rising trajectory. We note that the real interest rate differential on 1-year paper between India and the US is at almost 6%. Such considerable differential is expected to attract FII investments in the debt market, boost capital inflows and thereby support the INR.

Exhibit 5: Rising real interest rate differential between India and US on one-year yield
Nominal interest rate India 1QFY2012 2QFY2012 3QFY2012 4QFY2012 1QFY2013 2QFY2013 3QFY2013 4QFY2013 1QFY2014 29th July 2013 8.01 8.24 8.61 8.13 8.10 8.00 8.02 7.83 7.48 9.15 US 0.20 0.13 0.11 0.16 0.19 0.18 0.17 0.15 0.13 0.11 Nominal interest differential India U.S 7.81 8.11 8.50 7.97 7.91 7.82 7.85 7.68 7.35 9.04 Inflation rate (%, yoy) India 9.60 9.71 9.01 7.50 7.54 7.87 7.30 6.74 4.78 4.89 US 3.43 3.76 3.29 2.82 1.89 1.70 1.89 1.68 1.39 1.80 Real interest rate India (1.59) (1.47) (0.40) 0.63 0.56 0.14 0.73 1.09 2.70 4.25 US (3.23) (3.63) (3.18) (2.66) (1.70) (1.52) (1.72) (1.53) (1.26) (1.69) Real interest differential India U.S 1.64 2.16 2.78 3.29 2.26 1.66 2.45 2.62 3.96 5.94

Source: Bloomberg, Angel Research

July 30, 2013

Monetary Policy Statement FY2014

Macroeconomic stability gains precedence

External situation: We believe that post 1QFY2014 the CAD is likely to moderate and come in lower at about 4.0% of GDP during FY2014 as against 4.8% of GDP in FY2013 owing to a likely moderation in gold imports and pick-up in exports owing to INR depreciation and global economic recovery. The demand for gold imports at USD6.8bn and USD14.6bn in April and May 2013 respectively has largely been front-ended due to the decline in gold prices. In addition, investment demand for gold is likely to remain moderate due to its decline in prices, higher real interest rates owing to deceleration in inflation and various policy restrictions like raising the import duty on gold to 8% and linking gold imports with exports. Hence, gold imports are likely to normalize going forward. The volume of demand has come down drastically to 31 tonne during the month of June from 162 tonne in May and 141 tonne in April 2013.

Exhibit 6: Sharp INR depreciation since May 2013

(USDINR) 62.0 60.0 58.0 56.0 54.0 52.0 50.0 48.0 46.0 Feb-12 Feb-13 Apr-13 May-12 May-13 Apr-12 Jun-12 Aug-12 Sep-12 Mar-12 Nov-12 Mar-13 Oct-12 Jan-12 Dec-12 Jan-13 Jun-13 Jul-12 Jul-13

Exhibit 7: High gold imports contributing to trade deficit

(USD bn) 200.0 150.0 100.0 50.0 0.0 FY2008 FY2009 FY2010 FY2011 Ex gold FY2012 FY2013 INR/USD Trade deficit (USDINR) 58.0 53.0 48.0 43.0 38.0

Source: RBI, Angel Research

Source: RBI, Angel Research

Coupled with concern over a high CAD, India also remains vulnerable to its financing risks, particularly owing to risks from tapering off of the Feds QE3. In addition to structural measures needed to bring the CAD to a more sustainable level, the RBI continued to flag concern on its near-term financing. We believe that its recent measures are supportive to the extent that bond yields are attractive for foreign investors. The sharp INR depreciation is also detrimental for public finances since it increases the under-recoveries on administered fuel prices. For instance, the under-recovery on diesel in July 2013 stands at `9.45, at similar levels since January 2013 (despite six hikes by OMCs) owing to the INR depreciation. GDP Growth: We concur with the RBIs expectation that economic growth during FY2014 is likely to witness a slow-paced improvement. The RBI has revised its growth projection for FY2014 lower to 5.5% from 5.7% estimated earlier. We believe that growth in FY2014 may largely continue on similar lines as FY2013. On a positive note, agricultural growth seems poised for a recovery from a subdued 1.9% growth in FY2013. Since June so far, monsoon rainfall is 17% higher than the Long Period Average (LPA) as compared with deficiency of 24% in the previous year. Resultantly, estimates suggest that the area of sowing for kharif crop has reported an 18% increase as against sowing in the previous year. Owing

July 30, 2013

Monetary Policy Statement FY2014

to these factors, we expect a boost to agricultural production and hence rural consumption during FY2014. Industrial production is likely to remain weak and also impact the growth in services sector adversely. Industrial activity as measured by the IIP reported an almost flat 0.1% growth during April May 2013 as compared to subdued growth of 0.6% in the corresponding period of the previous year and 1.1% during FY2013. The RBI has also emphasized that the investment climate is inhibited by cost and time overruns, high leverage, deteriorating cash flows, erosion of asset quality and muted credit confidence.

Exhibit 8: Sector-wise contribution to GDP growth

(%) 12.0 10.0 8.0 6.0 4.0 2.0 0.0 FY2014Est FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 Agriculture & allied activities Industry Services

Exhibit 9: No sustainable recovery in industrial activity

(%) 15.0 12.0 9.0 6.0 3.0 (3.0) (6.0) May-10 May-11 May-12 May-13 Mar-10 Mar-11 Mar-12 Nov-10 Nov-11 Nov-12 Mar-13 Jul-10 Jul-11 Sep-10 Sep-11 Jul-12 Sep-12 Jan-11 Jan-12 Jan-13 IIP 3MMA IIP

Source: Mospi, Angel Research

Source: Mospi, Angel Research

The RBI has amply indicated that it intends to support growth, however to revert to that stance, stability in the currency remains key: The recent liquidity tightening measures by the Reserve Bank are aimed at checking undue volatility in the foreign exchange market and will be rolled back in a calibrated manner as stability is restored to the foreign exchange market, enabling monetary policy to revert to supporting growth with continuing vigil on inflation. Inflation: Headline WPI inflation for June 2013 eased to 4.9%, coming in the RBIs comfort zone for the third straight month. Core (non-food manufactured) WPI inflation edged to a 41-month low at 2.1%. Nevertheless, since the food basket accounts for 50% weightage in the Consumer Price Index (CPI), inflation as measured by the CPI inched towards double-digits at 9.9% in June 2013. We believe that going ahead food inflation is likely to ease owing to the decent rabi production, expectation of a good monsoon as compared to a deficient monsoon in the previous year and moderate Minimum Support Price (MSP) hikes for kharif crops. However despite the sluggish growth and demand scenario, the RBI maintains a cautious outlook on re-emergence of inflationary pressures largely due to INR depreciation stoking imported inflation, recent uptick in global crude oil prices and revisions in administered fuel and electricity prices. The RBI has estimated that 10% depreciation could lead to about 1% increase in the headline WPI inflation.

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Monetary Policy Statement FY2014

Exhibit 10: Moderation in WPI inflation as core recedes

(%) 12.0 10.0 8.0 6.0 4.0 2.0 0.0 Feb-12 Feb-13 Jun-11 Jun-12 Aug-11 Aug-12 Oct-11 Oct-12 Dec-11 Dec-12 Apr-11 Apr-12 Apr-13 2.1 Jun-13 4.9 WPI Inflation Core Inflation

Exhibit 11: Divergence between WPI and CPI inflation

(%) 12.0 10.0 8.0 6.0 4.0 2.0 Oct-12 Nov-12 Feb-12 Feb-13 Apr-13 May-13 Jul-12 Apr-12 May-12 Jun-12 Aug-12 Sep-12 Mar-12 Mar-13 Jan-12 Dec-12 Jan-13 Jun-13 4.9 WPI Inflation CPI inflation 9.9

Source: Office of Economic Adviser, Angel Research

Source: Office of Economic Adviser, Mospi, Angel Research

We believe that over the medium-term, the rise in real interest rates (owing to deceleration in inflation) is likely to boost the savings rate which has fallen to 30.8% in FY2012 from 36.8% in FY2008. We also expect this to result in a change in households preference from savings in physical assets like gold to productive financial assets.

Policy outlook
Overall, we believe the RBIs recent stabilization measures signal a reversal from the RBIs earlier stance of supporting growth until the INR is at a comfortable level. We believe that in the near-term, coupled with the growth-inflation scenario, developments on the CAD front and capital flows (which depend on global liquidity) would continue determining the monetary policy stance. The calibrated withdrawal of the RBIs tightening measures is conditional on forex stability, which itself could be challenging in the near-term due to global and domestic factors unless there are sharper measures from the government to address imports and exports. We believe that with these measures likely to continue over the next 1-2 months, we might see transmission of higher-than-anticipated interest rates into broader segments.

July 30, 2013

Monetary Policy Statement FY2014

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E-mail: research@angelbroking.com

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Monetary Policy Statement FY2014

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