Trans Scan Securities (P) Ltd

16 December 2010

RBI Mid Quarter Policy Review

The Reserve Bank of India (RBI) has kept the key rates
unchanged, keeping much in line with the expectations of a halt
in monetary tightening. This comes at a time when inflation has
started declining to below 8% from double digits till recently.
The RBI has also announced pumping in `48,000Cr into the
system to address issue relating to insufficient liquidity. The
RBI’s policy stance is along the lines of the Prime Minister's
Economic Advisory Council's observation that pointed towards
the system feeling the pinch of liquidity shortage.
Key rates

CRR Unchanged at 6%

SLR reduced to24% from prevailing 25%

Repo Rate unchanged at 6.25%

Reverse Repo Rate unchanged at 5.25%

Changes in Key Rates

♦ In the mid-quarter review, the RBI has kept unchanged the repo rate (short-term
lending rate) at 6.25% and the reverse repo rate (short- term borrowing rate) at
5.25%.
♦ The Cash Reserve Ratio (CRR) has also been kept unchanged at 6%. The Bank rate
has also been retained at 6%.

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♦ The RBI, however, decided to reduce the Statutory Liquidity Ratio (SLR) by one
percentage point to 24% with effect from December 18. SLR is that portion of
deposits which that banks park in government securities.
Expected Outcome of Policy Measures
♦ The permanent reduction in the SLR by 1% of NDTL coupled with the additional
liquidity support under the LAF will inject liquidity in the system sufficient to
maintain the projected growth rate of the domestic economy.
♦ The RBI’s policy measures are expected to bring down the liquidity deficit in the
system to a level close to RBI’s comfort zone and stabilize interest rates in the
overnight inter-bank market which is nearer to the operative policy rate of the apex
bank.
♦ The consumer spending is expected to be boosted as banks will not have the
inclination towards further rate hikes which can make consumer lans costlier.
Highlights of the Policy Review
Liquidity Measures
♦ The apex banking authority has decided to take the following steps towards easing
the liquidity situation:
a) Reduce the statutory liquidity ratio (SLR) of scheduled commercial banks
(SCBs) from 25% of their Net Demand & Time Liabilities (NDTL) to 24% with
effect from December 18, 2010; and
b) Conduct an open market operation (OMO) auctions for purchase of
government securities for an aggregate amount of ` 48,000 crore in the next
one month, to pump in liquidity into the system.
♦ The above two measures are expected to inject liquidity on an enduring basis of the
order of ` 48,000 crore.
♦ Due to the permanent reduction in the SLR by 1% of NDTL, the additional liquidity
support under the LAF announced by the Reserve Bank on November 29, 2010 will
now be available up to the extent of 1.0% (instead of 2.0%) of the NDTL of SCBs
from December 18, 2010 to January 28, 2011.
The Indian Economy: Present & Projected
♦ GDP Growth: GDP growth of 8.9% in Q2 of 2010-11 puts forward the strength of the
domestic growth impetus. Agricultural growth saw recovery aided by a good
monsoon. After deteriorating during August and September 2010, the index of
industrial production (IIP) registered growth of over 10% in October 2010. Various
economic indicators to confirm a strong underlying growth momentum. Lead
indicators of services sector activity continues growing at a healthy pace. These
developments underline the RBI’s projection of 8.5% real GDP growth for

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FY11. This will be appraised in RBI’s Third Quarter Review scheduled on

January 25, 2011.
♦ Inflation: The year-on-year headline WPI inflation declined to 8.8% in August 2010
and further to 7.5% in November 2010. Consumer Price Index (CPI) inflation for
industrial workers and rural/agricultural labourers declined to single digit rates
from August 2010, after remaining in double-digits for over a year. By and large the
reduction in inflation signals towards control easing of inflationary situation in food
prices on the back of a favourable monsoon. Food price inflation declined from an
average of 15.7% in Q1 FY11 to 12.3% in Q2, to 10.0% in October 2010 and further
to 6.1% in November 2010.
Despite moderation of inflation, inflationary pressures still looms large not only due
to high domestic demand but also as a consequence of higher global commodity
prices. Structural factors have resulted in the slower than expected pace of decline
in food price inflation. Concerns persist over the possibility of spill over of rising
international commodity prices into domestic inflation. Going forward, rising
input costs for the manufacturing sector coupled with aggregate demand
pressures on the domestic front could fuel domestic inflation and push it
beyond the Reserve Bank’s projection of 5.5% inflation by March 2011.
♦ Liquidity: The overall liquidity in the system has remained in deficit consistent with
the policy stance and was heightened by structural factors such as significantly
above-trend currency expansion coupled with relatively slow growth in bank
deposits despite credit growth acceleration in 2010-11, resulting in the tightness of
liquidity beyond RBI’s comfort level. But the primary cause of such liquidity
tightness has been the persistent hefty government cash balances which averaged
`84,000 crore since the Second Quarter Review of November2010, emulating in the
average net LAF repo amount of ` 1,01,000 crore.
While the liquidity deficit has been able to achieve, though not fully, the RBI’s
objectives of putting a leash on the raging inflation by curbing consumer spending
with several banks raising deposit and lending interest rates, excessive deficits will
bring on volatility in both availability and cost of funds rendering it difficult for the
entire banking system to sustain credit delivery. It has also adversely impacted the
IIP numbers which significantly moderated in August and September 2010. Despite
RBI’s attempt to ease out liquidity situation in the economy through OMOs and
LAFs, the extent of deficit could restrain ability of the banks to expand their balance
sheets in line the productive needs of the economy. Economic expansion warrants
primary liquidity that needs to be provided in a manner which is in agreement
with the contemporary monetary policy standpoint. Such liquidity injection
should not be interpreted as an alteration of the policy stance of the monetary
authority as inflation still remain a significant cause of concern.

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