Monetary policy

IMPACT ANALYSIS

The First Quarter Review, 2010-11

July 2010

Highlights of the Policy

• Repo rate raised by 25 bps to 5.75 per cent, while the reverse repo raised by
50 bps to 4.50 per cent with immediate effect.

• Cash reserve ratio (CRR) kept unchanged at 6.0 per cent.

• Real gross domestic product (GDP) growth forecast revised upwards from
8.0 per cent announced in April policy review to 8.5 per cent for FY11.

• The wholesale price index (WPI) inflation projection for end-March 2011
revised upwards to 6.0 per cent from 5.5 per cent announced earlier.

• Money supply projection retained at 17.0 per cent for FY11.

• Non-food credit and aggregate deposits growth projection retained at 20.0

and 18.0 per cent, respectively for FY11.

• RBI to undertake mid-quarter reviews roughly at an interval of about one and

half months after each quarterly review.

• High inflation remained the dominant concern that shaped the monetary
policy stance of the RBI in this quarter.

• The RBI has proposed to set up a working group to review the current
operating procedure of monetary policy of RBI, including the LAF.
 Overview
A clear move to control inflation 
Market participants expected RBI to raise the repo and reverse repo rates by 25 basis points in its July
policy. However, the RBI went a step ahead and raised the reverse repo rate by 50 basis points and the
repo rate by the expected 25 basis points, thereby narrowing the LAF corridor. These moves indicate that
the RBI wants its policy rate hikes to be more effective, will maintain a tighter control on liquidity and
tolerate lower volatility in call rates. The RBI’s hawkish stance reflects its growing confidence on the
sustainability of India’s growth momentum together with acute concerns on the inflation front. It has raised
its growth projection to 8.5 per cent for the current fiscal and year-end inflation projection to 6 per cent.

With policy rates normalising rapidly, I expect banks to raise both the deposit and lending rates within the
next quarter. The yields on 10-year G-secs are expected to harden to 8.3-8.5 per cent by March, 2011 from
their current sub-8 per cent levels as the RBI will continue to raise interest rates in the coming quarters. In
my opinion, the RBI will raise policy rates by another 50-75 basis points in the rest of the fiscal as inflation
has become broad-based, demand fuelled and therefore more worrisome.

In the last few months, inflation has been fast spreading to non-food items. The manufacturing inflation,
regarded as a proxy for core inflation, rose to 7.3 per cent in June, 2010. Rise in core inflation implies that
inflation is increasingly getting fuelled from demand side and requires the RBI to continue to raise interest
rates. We believe that the average inflation for the year will settle at 8.5-9.0 per cent. By March 2011, WPI-
based inflation should decline to around 6.5 per cent from double digits prevailing now as food inflation
softens and the RBI’s tightening measures tame the rise in non-food inflation. This of course assumes that
monsoons will stay on course for rest of the season.

Another development that has provided the RBI more flexibility in the conduct of the monetary policy is
the sudden and larger-than-expected windfall from 3G and WMA auctions. We believe that additional
revenues generated from these auctions will trim the fiscal deficit to 5 per cent of the GDP in the current
financial year. The need for an orderly conduct of the government’s borrowing programme required the
RBI to ensure lower rates of interest on government bonds and easy liquidity conditions. This was
hampering the RBI’s monetary tightening moves. The surplus revenue in the government’s kitty has
relaxed this constraint for the current fiscal. RBI’s move towards mid-quarter review of monetary policy
will help better manage expectations of market participants by reducing both surprises and shocks.

Dharmakirti Joshi
Chief Economist, CRISIL

CRISIL RESEARCH MONETARY POLICY IMPACT ANALYSIS, JULY 2010 2

 Impact on the Economy and Banking Sector

RBI narrows the interest rate corridor Chart 1: Policy Rates Raised
In its first quarter monetary policy review held today, Reserve Bank of India %
10
(RBI) while lauding the swift pace of economic recovery, reiterated its concern
over the prevailing high inflation rate. Accordingly, it raised the repo rate by 25 8
bps and the reverse repo rates by 50 bps. However, the cash reserve ratio (CRR)
CRR: 6.00%
was kept unchanged at 6.0 per cent. The increase in reverse repo rate is higher 6
than what we had expected. Also the resulting reduction in the LAF corridor
Repo: 5.75%
will reduce volatility in call rates. RBI’s current policy action will also put more 4

pressure on banks to raise their lending rates. Reverse Repo: 4.50%

2

Rising inflation remains the dominant concern for the RBI

0
Headline inflation has remained in double-digits since February 2010 and Apr-08 Oct-08 May-09 Nov-09 Jun-10
become much more generalized with each passing month. In light of the recent
fuel price hike and rising core inflation, it is unlikely that inflation would ease Source: RBI
any time soon. By March 2011, however, we expect WPI inflation to be around Chart 2: Inflation worry
6.5 per cent (RBI’s expectation stands at 6.0 per cent), as we expect food %
12 12
inflation to moderate due to better monsoon and non-food inflation to fall due
to RBI’s gradual monetary tightening (chart 2). 10 10

8 8

Industrial growth returning to sustainable levels 6 6

The growth momentum witnessed in the Indian economy during the last fiscal 4 4
has consolidated further and become more broad-based this fiscal. 2 2
Acknowledging this fact, the RBI has raised its growth projection for FY11 to
0 0
8.5 per cent from 8.0 per cent. Industrial growth led by investment, continues to
-2 -2
be robust. During, April-May 2010, IIP recorded a year-on-year growth of 14

Dec-09

Dec-10
Aug-09

Oct-09

Aug-10

Oct-10
Apr-09

Feb-10

Apr-10

Feb-11
Jun-09

Jun-10
per cent with as many as fifteen out of the seventeen industry groups
demonstrating positive growth (chart 3).
Source: Ministry of Industry and CRISIL computations
No CRR change in the current liquidity crunch seems a prudent decision Chart 3: Industrial growth back to trend
Liquidity in the system has been unusually tight for the past 2 months due to the y-o-y %
20 20
3G spectrum pay outs and advance tax outflows (Chart 5). This led to the
hardening of the call rates. The increasing gap between the deposit and credit
15 15
growth exacerbated the situation further and the banks had to borrow an
average of Rs 500 billion from the Reserve Bank of India's (RBI) special repo 10 10
window on a net daily basis since the beginning of June till July 23rd. However,
liquidity is expected to improve towards the month-end due to heavy G-sec 5 5
redemptions. In fact, to tide over the immediate liquidity crunch, the RBI has
extended the special repo window by another fortnight till July 30. Thus RBI’s 0 0
decision to keep the CRR unchanged is in line with the prevailing liquidity
Dec-09

Dec-10
Aug-09

Oct-09

Aug-10

Oct-10
Apr-09

Feb-10

Apr-10

Feb-11
Jun-09

Jun-10

conditions.
Source: CSO and CRISIL Computations
Short-term yields under pressure
Due to rising inflationary pressures, the first quarter of FY11 witnessed Chart 4: Liquidity tightens
considerable volatility in G-sec yields across both the shorter and longer end of Net LAF transactions, Rs bn (LHS) Call rates Repo rate Reverse repo rate
%
the maturity curve. The yield on the benchmark 10-year government paper fell 2000 11
to 7.59 per cent in June 2010 from 8.01 per cent in April 2010 due to
1000 9
expectation of lower government borrowings, but again moved up to 7.73 per
cent by the third week of July 2010. Given the sharp decline in liquidity in the 0 7

market, short-term yields have risen sharply in the recent weeks while the yield -1000 5
curve for longer maturity remained fairly stable. (chart 5). In the near term, this -2000 3
pressure is expected to remain due to increase in interest rates and tight
-3000 1
liquidity.
Apr-09

Apr-10
May-09
Jun-09

Dec-09
Jan-10

May-10
Jun-10
Jul-09
Aug-09

Oct-09
Nov-09

Mar-10

Jul-10
Sep-09

Feb-10

FY10 FY11

Source: RBI and CCIL

CRISIL RESEARCH MONETARY POLICY IMPACT ANALYSIS, JULY 2010 3

Impact on lending rates to be marginal Chart 5: Yield curve flattens
The hike in the repo and reverse repo rates is expected to be transmitted to the %

banking industry in the form of higher cost of funds. Lending rates are expected 9
to rise over the next 3 months, but the increase is expected to be lower than in
the marginal cost of funds. This is primarily due to two reasons – a) base rates 7
would not change significantly since they are mostly being calculated on the
basis of average cost of deposits and b) competitive pressures within the 5
industry will constrain any significant improvement in spreads.
3
3G auction and lower base leads to higher credit growth

Jan-08

May-08

Jul-08

Jan-09

May-09

Jul-09

Jan-10

May-10
Mar-08

Sep-08

Nov-08

Mar-09

Sep-09

Nov-09

Mar-10
The aggregate y-o-y growth in bank credit increased to 21.6 per cent as on July
2, 2010 as compared with 17 per cent as on March 26, 2010, essentially due to
1yr G-sec 10 Yr G-sec
the funds extended by banks to telecom companies for the payment of 3G and
broadband wireless spectrum fees as well as low base effect. CRISIL Research Source: CCIL
expects credit growth in 2010-11 to remain at 20-22 per cent. Factors such as Chart 6: Growth in credit and deposits
high capacity utilisation levels necessitating capital investments, continued %
thrust on infrastructure, and increase in retail credit will support credit growth 35

in the remaining months of 2010-11. 30

25
Deposit growth seen at 18-20 percent for 2010-11 20
As on July 2, 2010, growth in deposits declined to 15 per cent (y-o-y) vis-à-vis 15
17.1 per cent as on March 26, 2009 as depositors preferred to channelise their 10
savings to other investment avenues rather than parking them with banks. Due 5
to tight liquidity conditions, we expect banks to raise deposit rates to support 0
the strong credit demand. Consequently, deposits growth rate is expected to
Apr-08

Dec-08

Apr-09

Dec-09

Apr-10
Jun-08

Oct-08

Jun-09

Oct-09

Jun-10
Aug-08

Feb-09

Aug-09

Feb-10
increase and reach 18-20 per cent by the end of 2010-11.
Deposit Growth Credit Growth

Incremental CD ratio to decline Source: RBI and CRISIL Research

As a result of rapid credit growth in the first quarter of 2010-11, the incremental
credit-deposit ratio increased sharply to 99.9 per cent as on July 2, 2010 from Chart 7: CD and Incremental CD ratios
%
74.7 per cent as on April 9, 2010. CRISIL Research expects incremental credit- 120
deposit ratio for 2010-11 to decline gradually to 80 per cent, primarily on 100
account of an expected improvement in deposit growth. 80

60

40

20

-
Dec-08

Dec-09
Aug-08

Oct-08

Aug-09

Oct-09
Apr-08

Feb-09

Apr-09

Feb-10

Apr-10
Jun-08

Jun-09

Jun-10

CD ratio Incremental CD ratio

Source: RBI and CRISIL Research

CRISIL macroeconomic forecast for 2010-11
Parameter Forecast Table 1: Sector-wise bank credit growth
Agriculture 5.5 Growth, y-o-y %
Industry 8.6 Personal
Growth (%)
Services 8.4 Industry Services Loans Infrastructure
Total GDP 8.0 1QFY09 26.9 31.3 15.9 41.7
Inflation WPI Average 8.5-9.0 2QFY09 30.6 35.3 17.4 35.8
Interest Rate 10-year G-sec (Year-end) 8.3-8.5
3QFY09 30.2 27.6 14.6 38.5
Exchange Rate Re/US$ (Year-end) 43.5-44.0
4QFY09 25.8 19.2 8.5 35.1
Fiscal deficit Fiscal Deficit (as a % of GDP) 5.0
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

CRISIL RESEARCH MONETARY POLICY IMPACT ANALYSIS, JULY 2010 4

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