Mid-Quarter Monetary Policy Preview

RBI fast paces rate normalisation September 16, 2010

In its first mid-quarter monetary policy review held today, Reserve Bank of India (RBI) Chart 1: Policy Rates - Move towards normalisation
raised repo rate and reverse repo rate by 25 bps and 50 bps respectively, thus narrowing 10
the LAF corridor further to 100 bps. RBI’s decision was mainly influenced by a still
8
unacceptably high level of inflation but steady growth prospects. The prevalence of
Repo: 6%
negative real interest rates despite interest rates hikes in the past also weighed on RBI’s CRR: 6%
6
decision. Striking a note of caution regarding the uncertain global scenario, RBI said that
the big picture has not worsened significantly since its July 2010 review. With this move 4

the central bank so far has increased the repo by 100 bps and reverse repo by 150 bps in R everse Repo: 5%
2
2010-11.
0
Apr-08 O ct-08 May-09 Nov-09 Jun-10
Repo rate to remain the operative rate as liquidity will remain stressed
The net liquidity in the banking system which had moved into deficit territory since June,
2010 moved into the surplus territory in the last week of August 2010, due to various Source: RBI

liquidity boosting measures introduced by the RBI. Although the RBI absorbed average
liquidity to the tune of Rs 157 billion during the period August 23-September 8, the liquidity Chart 2: Liquidity to remain under pressure
situation has again slipped into deficit territory since last couple of days, making the repo Net LAF t ransact ions, Rs bn (LHS) Call Rat es (%)
2000 7
rate the operative policy rate (Chart 2). Going forward also the operative rate is likely to be
1500 6
repo rate due to the large outflow of liquidity from the system on account of advance tax
5
payment. This also means better monetary policy transmission into the economy. The 1000
4
narrowing of the LAF corridor is expected to reduce volatility in call money rates. 500
3
WPI inflation moderates but still remains a concern 0
2
Notwithstanding the slight moderation in WPI inflation to 8.5 per cent (with the new base) -500 1
in August 2010, it is still at an unacceptably high level and is way above its trend level of -1000 0
5.0-5.5 per cent during the past decade (Chart 3). Despite some early signs of downturn
in non-food manufacturing inflation (proxy for core inflation), overall inflation is expected to
remain elevated for some more months. This clearly has implications for real interest rate,
which is currently in the negative territory and is impeding healthy deposits growth. Against Source: RBI and CCIL
this backdrop, RBI wants to continue its gradualist approach towards interest rate
normalisation, in order to firmly anchor inflationary expectations. Chart 3: Inflation remains above RBI’s comfort level

1 2 .0 W PI
Recent volatility in industrial production raises some doubt
The Industrial production (IIP) growth has remained strong so far in this fiscal, with June 8 .0 R B I's c o m fo rt
le v e l = 5 %
being the only exception. Industrial growth has averaged 11.4 per cent in the first 4 months
4 .0
against a tepid 4.7 per cent during the same period last year. Growth, particularly, in
capital goods and consumer-durables sector has remained strong, reflecting buoyancy in 0 .0
both investment and consumption demand. However, high volatility in growth during the
past two months has raised some doubts about the effectiveness of the index to capture -4 .0
Jan-08

Apr-08

Oct-08

Jan-09

Apr-09

Oct-09

Jan-10

Apr-10
Jul-08

Jul-09

Jul-10
the underlying momentum in the industrial sector. The robust 13.8 per cent IIP growth in
July 2010, after removing the capital goods component shows an increase of mere 7.0 per
cent (chart 4). For the remaining months of this fiscal we expect industrial growth to be in
single-digits due to the high base effect of last year. Source: Ministry of Industry

Table 1: CRISIL macroeconomic forecast for 2010-11 Chart 4: Volatile capital goods inflate IIP
P a ra m e t e r F o re c a s t Overall IIP IIP minus capital goods
20.0
A griculture 5 .5
Industry 8 .6 15.0
13.8%
G ro wt h ( %)
Services 8 .4
10.0
To tal GDP 8 .0
Inf la t io n WP I A verage 8 .5 - 9 .0 5.0 7.0%

Int e re s t R a t e 10-year G-sec (Year-end) 8 .3 - 8 .5

0.0
E xc ha nge R a t e Re/US$ (Year-end) 4 3 .5 - 4 4 .0
Apr-09

Jun-09

Oct-09
Aug-09

Dec-09

Feb-10

Apr-10

Jun-10

F is c a l de f ic it Fiscal Deficit (as a % o f GDP ) 5 .0

Source: CSO and CRISIL estimates

1
 Impact on the Banking Sector
Lending rates expected to increase in the coming quarters Chart 5: Growth in credit and deposits
The increase in the repo rate by 25 basis points is expected to be transmitted to the
35%
banking sector in the form of higher cost of funds. Against this backdrop, CRISIL Research
30%
expects lending rates to rise in the coming quarters. However, the increase in lending
25%
rates will be lower than the increase in the marginal cost of funds due to calculation of the
20%
base rate on average cost of deposits and competitive pressures prevailing in the industry.
15%

10%
Credit growth expected to pick up marginally
5%
The aggregate y-o-y bank credit growth of 21.6 per cent as on July 2, 2010, on account of
0%
large borrowings for 3G spectrum and broadband wireless access auctions, and advance
Aug- Nov- Feb- May- Aug- Nov- Feb- May- Aug-
tax payments, moderated to 19.4 per cent as on August 27, 2010. Credit growth is 08 08 09 09 09 09 10 10 10
however expected to pick up marginally in the near term due to high capacity utilisation
Deposit growth Advances growth
levels necessitating capital investments, and increase in infrastructure and retail credit.
CRISIL Research expects credit growth in 2010-11 at 20-22 per cent. Source: RBI and CRISIL Research

Increase in bank deposit rates imminent Chart 6: CD and incremental CD ratios

Despite hiking deposit rates by 25-150 bps in the second quarter of the financial year, the 120%
deposit growth rate, after peaking at 17.1 per cent on March 26, 2010, has ranged at 14-
100%
15 per cent. This is primarily due to investors preferring to channelise their savings to other
80%
investment avenues on account of negative real interest rates on bank deposits. Hence,
we expect banks to increase deposit rates to mobilise resources to support credit growth. 60%

Consequently, the deposits growth rate is expected to reach 18-20 per cent by end 2010- 40%
11. 20%

0%
Incremental credit-deposit ratio declines, expected to fall further Aug- Nov- Feb- May- Aug- Nov- Feb- May- Aug-
Moderation in credit offtake and stable growth in deposits had led to incremental credit- 08 08 09 09 09 09 10 10 10

deposit ratio declining to 92.4 per cent on August 27, 2010 from 99.9 per cent on July 2, Credit-deposit ratio Incremental credit deposit ratio

2010. CRISIL Research expects incremental credit-deposit ratio for 2010-11 to decline
CD: Credit-deposit
further to 80.0 per cent, primarily on account of expected improvement in the growth of
Source: RBI and CRISIL Research
deposits.

Table 2: Sector-wise bank credit growth

(Growth y-o-y %)
Industry Services Personal Infrastructure
loans
1QFY09 26.9 31.3 15.9 41.7
2QFY09 30.6 35.3 17.4 35.8
3QFY09 30.2 27.6 14.6 38.5
4QFY09 25.8 19.2 8.5 35.1
1QFY10 21.2 20.5 5.5 35.1
2QFY10 17.9 11.0 2.3 44.7
3QFY10 14.2 7.9 0.7 47.2
4QFY10 20.1 15.0 4.7 42.3
1QFY11 25.8 14.1 6.5 44.3
Source: RBI and CRISIL Research

MID-QUARTER MONETARY POLICY IMPACT ANALYSIS, SEPTEMBER 2010 2

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