India's central bank takes a breather

The RBI has taken a breather after following the aggressive tightening path since beginning-CY10. As headline inflation has started softening, managing liquidity seems to have become the main focus area for the RBI. We expect further tightening in policy rates, in FY12.

Key policy rates remain unchanged. In line with expectations, the RBI left the repo rate (at which banks borrow from the RBI) and the reverse-repo rate (at which banks park money with the RBI) unchanged, as per its mid-quarter monetary policy review today. The cash reserve ratio (CRR) was kept unchanged at 6%.

Break from policy rate hikes. After six consecutive policy rate hikes since Feb ’10, the RBI has taken a breather. The RBI has hiked repo rate by 150bps, reverse-repo rate by 200bps, and CRR by 100bps since beginning-CY10.

Focus on liquidity. In a bid to address the prevailing acute liquidity shortage in the system, the RBI took two major steps – One, it cut the statutory liquidity ratio (SLR) by 1%, to 24% of net demand and time liabilities (NDTL). This, however, has been counter-balanced by reducing the additional liquidity support under the LAF announced on 28 Nov ’10, to 1% of NDTL from 2%. Two, it announced that it would purchase government securities of `480bn within the next month through the open market operation (OMO).

Liquidity to remain tight. Despite RBI’s measures, we do not expect significant improvement in the liquidity situation in the near term. Post mid-Jan ’11, however, the tight liquidity situation may start easing.

RBI retains broad projections. The RBI has kept the FY11 GDP growth projection at 8.5%. As regards inflation, the RBI has indicated possible upside risk to its Mar ’11 target of 5.5% in the face of rising international commodity prices. WPI inflation considerably softened to 7.5% in Nov ’10, the lowest since Jan ’10.

Policy rate outlook. In line with our estimates of softening of both inflation and real growth rates in 2HFY11, we expect the RBI to maintain policy rates at current levels for remaining-FY11. However, RBI’s medium-term focus is likely to remain biased towards tightening. After softening to ~5.5% levels by Mar ’11, we expect inflation to start inching up post May ’11. Hence, we believe key policy rates would be further tightened by another 75bps in FY12e. Transmission of monetary tightening would keep upward bias for both lending and deposit rates

India moving ahead of peers by adopting hawkish stance on monetary policy

In its first quarterly review of Monetary Policy FY11, the Reserve Bank of India (RBI) hiked the repo rate (the rate at which banks borrow from the RBI) by 25bps to 5.75% and the reverse repo rate (the rate at which banks park funds with the RBI) by 50bps to 4.5%. The 50-bps hike in reverse repo rate was higher than the street expectation (25bps hike in both rates). Since the repo rate is the operating rate in the current liquidity shortage scenario, the 50 bps hike in the reverse repo rate will have only a limited role to play. From the policy document it is clear that the RBI’s focus has shifted to anchoring inflationary expectations in the economy.

Though the RBI seems sanguine on the economic recovery front, it showed deep concerned about the high inflation in the economy. The central bank increased the economic growth forecast for fiscal year 2010-11 to 8.5% from 8% earlier and the year-end inflation target to 6% from 5.5% earlier.

Another important announcement is that the RBI will now undertake mid-quarter reviews roughly at the interval of about one and half months after each quarterly review. Now this is welcome step, given the fact that in recent years, there have been several occasions when the RBI had to take off-cycle policy actions in response to macroeconomic developments. In fact the frequency of the intra policy actions had increased off late. For example, intra policy rate actions were taken in April, June, Sep and Dec in 2008; in Jan and March in 2009; and in March and July in 2010 so far.

On the policy rate outlook, assessing the current scenario, any change in policy rates during the 16 Sep ’10 mid-quarter review is unlikely. However, I expect 25-bps hike in repo and reverse-repo rates in the second quarterly monetary policy review on 2 Nov ’10

Is the recent recovery in the global economy sustainable?

The developed economies like the US, Canada, Japan, Germany, France, S. Korea all have managed to pull out of the so called worst recession in seven decades and have posted quite impressive GDP numbers in last two-three quarters. The two countries which are leading the world economic growth namely China and India have also clocked stellar GDP growths in recent quarters. In addition to that, the US labour market has also shown signs of improvement in last two-three months. Data prints from the US housing market have been quite an icing on the cake in the recent months.

But as we all know that much of it is the outcome of extremely easy monetary policy and gigantic fiscal stimuli launched around the world in last one year and a half. Now the key question at this juncture is that once the policy makers start a gradual exit from the monetary and fiscal stimuli, will the growth momentum sustain? Or the global economy will fall flat once the monetary and fiscal support inevitably withdrawn. And the on-going Europe debt-crisis adds further to the uncertainty to the outlook of the global economy.

Government contribution made all the difference: Government spending has been the key factor behind the strong GDP growth witnessed by major economies in the world. Given the fact that fiscal deficit has increased sharply in most economies in the world, the government support to the economy can not sustain for long. And ultimately the governments will have to withdraw their support which is expected to start in 2010. I, therefore, don’t expect 2010 to be a year of robust economic growth. In fact, according to me India’s GDP growth for FY11 is likely to remain lower than that of FY10. Nevertheless, I expect the macro fundamentals of Indian economy to improve significantly in FY11.

Now talking about the sustainability of the growth momentum, the probability of a double dip recession is very low at this juncture. But the global economy is going to take a while to reach the normalcy level and the global economic recovery process is likely to be rather gradual.

India's GDP growth is more realistic in Dec 09 quarter

India’s GDP grew 6% in 3QFY10, following strong growth of 7.9% in 2QFY10. The number was substantially lower than consensus’ estimates (6.8%). The major surprise came from social and personal services, which declined -2.2% in 3QFY10. If you look at he numbers more closely, you will find that this growth number (6%) is actually better than the previous quarter growth of 7.9%. You must be wondering that this guy has lost it completely. Well, I will just say let the numbers speak to you. Here is the table.

The growth rate of 6% in 3QFY10 seems to be more close to reality than last quarter’s growth rate, which was inflated by government consumption. In 3QFY10, government consumption declined 10.3%, following an increase of 26.9% in 2QFY10. Excluding government consumption, GDP (at constant market prices) grew impressively by 8.5%, as against 4.8% in 2QFY10. That is why I was saying that this quarter growth is better than that of the previous one.

Well this is not it. There are some more interesting points to come. Industry which has 28% weight in the overall GDP, witnessed a strong rebound in 3QFY10. It grew by 11.6%, way ahead of the 7.5% growth average recorded in the past decade. Manufacturing grew a whopping 14.3%, the highest growth in more than a decade.

On the down side, services, having a weight of 56% in the GDP, recorded a decade low growth of 6.3%, dragging down economic growth. Another problem for the economy is its low investment growth. Real investment grew at a tepid rate of 5.1% in 3QFY10. Investment growth continues to be sluggish with a meager 2.4% average growth in the last seven quarters. The investment cycle, however, seems to have bottomed out. Nevertheless, we do not expect a strong recovery in investment before FY12.

The Economic Survey FY10 estimates FY11 GDP growth at 8.2%, which seems quite optimistic. Until India witness a strong recovery in the investment cycle, which was the main driver of growth during FY04-FY08, returning to the 9% kind of growth levels seems unrealistic. Investment growth was around 18% during the FY04-08 period. Furthermore, fourth quarter GDP numbers from many developed economies indicate the fragility of the much-talked-about global recovery.

RBI takes on liquidity

In a rather hawkish move, the RBI increased the cash reserve ratio by 75 basis points to 5.75% in order to address the ongoing liquidity overhang in the system. Other policy rates were left unchanged. The move is expected to drain Rs 360 billion from the system. In the last one month, the overall liquidity in the market has been around Rs 600 to Rs. 800 billion. So factoring in RBI’s rate action, there will still be around Rs 300 billion to Rs 500 billion left in the system.

The comforting factor here is that central government is done with its massive market borrowing programme for the current fiscal. Nevertheless, the move is expected to raise short-term rates and will impact banks negatively. Banks would lose out on account of the increased CRR outgo. Given the current credit demand and deposit growth scenario, it would be difficult for banks to even partially pass-through the same through either a hike in lending or a cut in deposit rates.

As the wholesale price inflation surged to 7.3% in Dec ’09 and the consumer price inflation remains in the teens, the RBI is now focusing more on managing inflationary expectations. The RBI, however, has pointed out that the recovery is yet to fully take hold and that it would require sequenced withdrawal of exit from the current extremely accommodative regime.

To sum up, the recent aggressive tightening in the CRR indicates that the RBI will not take any rate action until the next policy review on 20 April 2010.