25 January, 2011

Third-Quarter Review of Monetary Policy FY2011

As expected, RBI continued with its motto of ‘Festina Lente’ or “make haste
slowly’. RBI took another baby step and hiked Repo and Reverse Repo rates by 25
bps. But RBI maintained a hawkish tone on inflation and so, expect more hikes.

Policy Rates hiked and CRR/ SLR unchanged:

• The Reserve Bank of India hiked Repo and Reverse Repo rates by 25 bps to
6.50% and 5.50% respectively.
• CRR was left untouched at 6.00%. SLR was left at 24%. Economy
Update
Liquidity Measures:
• The second LAF, for additional liquidity support to scheduled commercial
banks to the extent of up to 1% of NDTL, is extended to 8th of April. It was
set to expire on Jan 28, 2011.
• RBI will constantly monitor the credit growth and, if necessary, will engage
with banks which show an abnormal incremental credit-deposit ratio.

Key Highlights:
• The US economy is showing signs of stabilising. Although uncertainty
continues in the Euro area, there is an overall improvement in the global
growth prospects. Signs of inflation in the advanced countries are only
incipient, but many EMEs have been facing strong inflationary pressures.
• In India, growth has moved close to its pre-crisis growth trajectory (8.9%
GDP in 1H FY11), even in the face of an uncertain global recovery.
• Inflationary pressures have reemerged again. Non-food manufacturing
inflation has remained sticky. There are signs of rapid food and fuel price
increases spilling over into generalised inflation. There is some evidence of
rising demand side pressures as seen in rapid bank credit growth, robust
corporate sales and buoyancy in tax revenues. Global commodity prices
have risen sharply which has heightened upside risks to domestic inflation.
• RBI also mentions that without meaningful output enhancing measures, the
risks of food inflation becoming entrenched loom large and threatens
sustainability of the current growth momentum.
• Domestic growth momentum to stabilise, with GDP growth in FY12 declining
somewhat. Inflation will likely moderate in 1QFY12 but upside risks remain.

Expected Outcomes
• Contain the spill-over from rise in food, fuel prices to generalised inflation.
• Rein in rising inflationary expectations, which may be aggravated by the
structural and transitory nature of food price increases.
• Be moderate enough not to disrupt growth.
• Continue to provide comfort to banks for liquidity management operations. Trend in Key Policy Rates

Bottomline:
• RBI has tried to maintain a balance between Growth and Inflation. But it
continued with its hawkish stance on inflation. Expect further hikes as
RBI still has unfinished business as regard to taming inflation.
• Even though market expected a 50 bps hike, the 25bps hike was in line
with our expectation. A larger hike at this point will be like wasting
precious ammunition as inflation is moderating, industrial growth is
slowing and lending rate is rising. If necessary, RBI can hike again
during its March policy meet.
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 GDP and Inflation Forecast
Macro Indicators Previous projection for FY11 Actual at present Projection for FY11
GDP 8.5% 8.9% (1H FY11) 8.5% with upward bias
Inflation (end Mar) 6.0% 8.4% (Dec, 2010) 7.0%
Money Supply (M3) 17.0% 16.5 (Dec 31, 2010) 17.0%
Aggregate Deposit - 16.6% (Dec 31, 2010) -
Non-Food Credit Growth 20.0% 24.6% (Dec 31, 2010) 20.0%

Liquidity management has been a major challenge for RBI in the recent period

• Liquidity had tightened considerably since mid-

May after the 3G/broadband auction outflow from
the banking system.
• The situation going forward only worsened on
account of around Rs 4,18,000 cr in tax outflows
(till Nov), the net borrowings of the government
around Rs 3,40,000 cr till date as well as higher
currency with public, Govt expenditure lag and
sluggish deposit growth compared to credit.
• Another major drainer has been the disinvestment
of Govt stake in PSUs. This resulted in effective
tightening of short-term money market rate by 150
bps from the reverse repo to above repo rate.
Govt balance with the RBI (in Rs cr)
• But frictional tightness in liquidity reflected
unusually large government surplus balances with
the Reserve Bank as Govt expenditure lagged the
revenue flows into Govt coffer.
• During the 3Q of 2010-11, the Got surplus with
the RBI hovered in the range of 1.0% - 3.0% of
NDTL of banks. The effective impact on liquidity,
therefore, was equivalent to an increase in CRR
by 100-300 bps.
• Although RBI prefers tight liquidity as it helps in
proper transmission of monetary policy, the
system deficiency is “significantly in excess of the
RBI’s comfort zone of (+/-) 1% of NTDL of banks”
i.e ~Rs50,000 cr and is disruptive for the
economy.

• RBI has already taken several liquidity measures like second LAF, permanent cut in SLR by 1%,
OMOs (Rs 67,000 cr since Nov’10) as well as reduced Gsec borrowing.
• In today’s policy statement, RBI announced the extension of second LAF to 8th April. Liquidity will be
significantly negative in March on account of corporate advance tax outflow as well as indirect tax
outflows and ONGC disinvestments.

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Timeline of Measures Taken by RBI since 16-Sept-08
Date Measures
16th Sep’08 • Raised interest rate ceilings on NRI deposits.
• Provided additional liquidity by:
(a) banks to avail additional liquidity support under LAF up to 1% of NDTL (a de-facto SLR cut)
(b) Extended the Secondary LAF (SLAF) to a daily basis.
6th Oct’08 • Reduced the Cash Reserve Ratio by 50bs to 8.5% - first cut since June 2003.
10th Oct-08 • Reduces CRR by 100bps to 7.5%
th
14 Oct-08 • Announces 14-day Term Repo Facility to meet liquidity requirements of Mutual Funds.

15th Oct-08 • RBI cuts CRR by 100bps to 6.5%.

• Allowed banks to borrow up to 0.5% of their NDTL to meet liquidity requirements of Mutual Funds.
• Special Mkt Operations for Oil bonds instituted once again
• Interest rates on NRI Deposits increased.
• Rs250bn under the Agricultural Debt Waiver Scheme made available to banks immediately.
20th Oct’08 • RBI cuts Repo Rate by 100bps to 8%.
24th Oct'08 • During its policy meet on 24th Oct, RBI maintained status que and kept rates unchanged at:
– Repo Rate: 8%; Reverse Repo Rate: 6%; CRR: 6.5%

1st Nov’08 • Repo rate cut by 50bp to 7.5%. CRR cut by 100bp to 5.5%. SLR cut of 100bps to 24%.
• A special refinance facility under which banks will be provided refinance up to 1% of bank's NDTL
on 24 October 2008 at repo rate up to a max period of 90 days.
• Banks can borrow upto an aggregate 1.5% of NDTL for financing NBFCs and mutual funds. With
this move, effective SLR stands at 22.5%.
• Buy back of MSS securities to fund fiscal slippage.

7th Nov’08 • Reserve Bank of India to provide forex liquidity to Indian public and private sector banks having
foreign branches or subsidiaries, through forex swaps of tenors upto three months.
6th Dec’08 • RBI reduced policy rates:
– The repo rate under the LAF is reduced by 100 bps from 7.5% to 6.5% bringing the total
reduction to 250bps since October.
– The reverse repo rate was reduced by 100 basis points from 6.0% to 5.0%. It is the first such
cut in the current cycle.
• Measures for troubled sectors such as Real Estate, SME Segment, Exporters, and FCCBs.
2nd Jan’09 • RBI cuts the Repo Rate and Reverse Repo rate by 100bps each to 5.5% and 4% respectively; and
the CRR by 50bps to 5%.
27th Jan’09 • No changes to rates in 3Q Policy Review, but timelines for refinance facilities extended to Sept'09.
4th Mar’09 • RBI Reduces Repo, Reverse Repo Rates by 50bps each to 5% and 3.5% respectively.
st
21 Apr’09 • RBI cut repo and reverse repo rate by 25 bps to 4.75% and 3.25%. CRR left the unchanged.
28th July’09 • Left key rates unchanged
27th Oct’09 • Key policy rates unchanged. SLR hiked back to 25%.
• Unconventional measures withdrawn. Provisioning for banks increased.
29th Jan’10 • CRR hiked by 75 bps in two stages from Feb 13, Policy rates kept unchanged.

19th Mar’10 • Repo and Reverse Repo rates hiked by 25 bps in an inter-meeting move.
th
20 Apr’10 • CRR, Repo and Reverse Repo rates hiked by 25bps to 6%, 5.25% and 3.75% respectively.
2nd July’10 • Repo and Reverse Repo rate hiked by 25 bps, Additional liquidity measures announced.
27th July’10 • Repo rate hiked by 25 bps to 5.75%, Reverse Repo by 4.50%, CRR left unchanged.
th
16 Sept’10 • Repo rate hiked by 25 bps to 6%. Reverse Repo rate hiked by 50 bps to 5%.
16th Dec’10 • Policy rates remain unchanged. CRR left untouched. SLR cut by 1%. OMO announced.
25th Jan’11 • RBI hiked Repo and Reverse Repo rate by 25 bps to 6.50% and 5.50%.

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