In the first quarter review of the annual monetary policy, the Reserve Bank of India (RBI) has kept the policy rates unchanged as per expectations but hiked the cash reserve ratio (CRR) by another 50 basis points to 7%, which has come as a surprise. Higher money supply and reserve money growth coupled with risks from higher commodity and oil prices to price stability and inflation are likely to have forced the RBI to take the rather pre-emptive step. In addition to price stability the RBI has added maintenance of financial stability in the policy stance.
The markets (bond, equity and currency) reacted sharply to the hike. Bond yields moved up by 12 basis points after the increase in CRR and closed eight basis points higher at 7.84%. The equity markets dipped sharply but later recovered to close in the green (Sensex up 290 points). The rupee also appreciated by 0.5% to close at Rs40.34 per US dollar.
Liquidity management to receive higher priority The RBI has assigned highest priority to liquidity management under the current economic scenario. To achieve this end it has undertaken certain measures mentioned in the table below. Impact of CRR hike on the banking sector The unexpected CRR hike initially took the markets down but we witnessed a smart recovery after the sharp intra- day dip. Banks are currently not receiving any interest on CRR and the 50-basis-point hike in the CRR would impact the banks’ net interest margins by four to six basis points and their FY2008 earnings by 1.6-2.8%. However, the removal of the ceiling of Rs3,000 crore on the reverse repo would realign call money rates to 6-7.75% from below 1% and allow large liquidity surplus banks like State Bank of India, Punjab National Bank and Bank of Baroda to earn higher interest in the call and repo markets. Hence the effective impact of the hike on the FY2008E earnings of large banks would be marginal. Banks would hold back lending rate cuts; revision in earning estimates likely The rising defaults and slowdown in credit growth currently don’t make a conducive environment for another round of lending rate hikes. Rather we feel banks would try to mitigate the increased costs by lowering the deposit rates and delay the expected cut in the lending rates. In the current liquidity surplus situation the CRR mop up would not impact the banks’ ability to lend. The average liquidity in the system is in the range of Rs50,000-60,000 crore, while the CRR would reduce it by Rs15,000-16,000 crore. The deposit rates have already started to decline and the delay in lending rate cuts would result in higher incremental spreads
(despite the CRR hike) which we feel is not factored into the earnings for banks and provide a scope for upward revision in earnings Interest rates and rupee likely to remain firm With most banks having run out of excess statutory liquidity ration (SLR) holdings the gap in the credit and deposit growth is slowly going to close as we are witnessing in the current growth rates. The incremental credit deposit (CD) ratio has steadily declined from 120% levels to 75% at present. Hence, the incremental loan growth has to be funded largely out of fresh deposits (unless RBI reduces SLR holding requirements which is unlikely in a liquidity surplus situation). The first half of any financial year witnesses a slack in credit demand and after the CRR hike, the lending rate cut which banks were mulling would be deferred. Going forward if credit growth picks up in the
second half then interest rates would continue to remain firm and this could start impacting the overall economic growth. The high domestic interest rates would continue to keep the rupee strong however significant appreciation is not expected as the RBI is expected to play a much active part going forward.
RBI remains hawkish despite the decline in headline inflation The RBI states that the heartening feature of recent macro- economic developments has been the decline in headline inflation which the RBI attributes to the pass-through effects of monetary, fiscal and supply-side measures in conjunction with seasonal factors, especially the moderation of food prices with the arrival of the rabi harvest. However, the recent surge in global prices of several agricultural commodities and crude pose a risk to inflation. The elevated levels of asset prices and the re-emergence of pricing power among producers are potential threats to inflation expectations. RBI’s outlook for FY2008 inflation remains unchanged at 5% and the medium term target remains at 4-4.5%.
Exchange rate management not getting the deserved attention The RBI has kept its exchange rate management policy
unchanged contrary to the market’s and our expectations. The RBI’s exchange rate policy in recent years has been guided by the broad principles of careful monitoring and management of exchange rates with flexibility, without a fixed target or a pre-announced target or a band, coupled with the ability to intervene, if and when necessary. We expect the rupee to remain firm. The market was expecting some curb on foreign inflows via the overseas borrowing route. Absence of any such measure also supported the rupee and it closed 0.5% up at Rs40.34 per US dollar.
Other key takeaways from the policy The GDP forecast for FY2008 is retained at 8.5% and =the prospects of growth remain positive led by industry and services sectors. On the agricultural front, the outlook is somewhat unclear and would depend on the spread and intensity of the southwest monsoon. From June 1 to July 25, 2007 , the rainfall has been 4 per cent above the long period average, according to the Indian Meteorological Department .
- Demand pressures are still visible in the consumer non- durables, although signs of some moderation have begin to set in in the commercial vehicles and auto parts segments.
- The export demand continues to remain strong, except in some industries like textiles, which are facing capacity constraints and rising cost conditions.
- The monetary and banking aggregates continue to rise at persistently high rates, while there is a moderate slackening of non-food bank credit growth.
- The RBI has stated that growth in the emerging market economies will be affected by developments such as upward movement in oil prices, adverse developments in the US housing market and large leveraged positions in financial markets.
Conclusion :The RBI has surprised the markets again with an unexpected CRR hike and sounded hawkish on inflation expectations too. A lot was expected from the policy with regard to exchange rate management. The policy, however, is foundwanting in this regard. Although the RBI sounds rather confident regarding economic growth, some of the surveys that it conducts regularly has given a mixed response especially for the export-oriented sector. Our calculations suggest that a significant contribution to the manufacturing led industrial growth currently comes from the sugar cane production and wood products. But due to the seasonality of these sectors and a slowdown in automobiles production industrial growth will remain moderate going forward. Firm interest rates and a strong currency could impact the overall growth story hence we feel the RBI has overlooked the importance of growth and has rather focused more on inflation control.
At a Glance
Measures announced Removed the Rs3000 crore reverserepo cap,but retained the discretion to re-impose the cap No second reverse repo or repo auctionsHas the option to conduct liquidityaffected facility (LAF) at fixed and variable rates
and Its Impact : The removal of the reverse repo cap provides the RBI greater flexibility to absorb higheramount of liquidity from the system. This could in turn mean that the RBI’s participation in the foreign exchange market would increase leading to a higher liquidity in the system (liquidity increases when RBI buys dollars and releases rupees into the system), which the central bank wants to suck up via the reverse repo window. But the policy could act like a double-edged sword where in on one hand the RBI supports the rupee but on the other had due to the carry trade arbitrage (borrowing in Yen which attracts lower interest rates, converting them into rupees and deploying it in the domestic market at much higher rates) the rupee continues to appreciate.
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