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August 2011

Monetary Policy Review

October 25, 2011

Rate hike Could it be the last one?

With another 25 basis points hike in repo rate, the Reserve Bank of India (RBI) has reinforced its intent of according top priority to inflation control. Inflation is not just high, but has become persistent. This in our view justified another rate hike, since inflation will not only have to be brought down to around 5 per cent, but will also have to be maintained at around that level to tame inflation expectations. This has been elusive so far. Some factors however, are hinting at a rising possibility of 7 per cent WPI-inflation by March 2012. Firstly, average food inflation in the year so far is lower than in the past two years. Given that rainfall has been normal this year, this could keep food inflation in check. Second, due to weak global growth there is not much upside to commodity prices, which have already softened. Moreover, unlike in 2007, the probability of adverse supply shocks (for example crude oil) too is low. Despite this, strong domestic demand buoyed by elevated income levels, supply-side bottlenecks, and a depreciating rupee are likely to exert upward pressures on overall inflation. Todays rate hike could be the last one, only if downward pressures on inflation remain dominant.

Persistence in inflation and monetary stance WPI - based inflation has stayed above 9 per cent for the past 19 months, while CPI-based inflation has been higher than 8 per cent for the past 38 months. Inflation pressures have become persistent in the last few years. In the past 66 months (since April 2006), WPI inflation stood above 5 per cent in 48 months; above 6 per cent in 44 months; above 7 per cent in 34 months; and above 8 per cent in 28 months. The last rate hike cycle (in 2008) saw the repo rate peak at 9 per cent, as inflation stayed above 7 per cent for about 9 months. In the current cycle, however, inflation has been much more stubborn, inviting todays rate hike.

Chart 1: Inflation persistence and rate hikes

Inflation %yoy 13.0 11.0 9.0 7.0 5.0 3.0 1.0 -1.0 2.00 8.00 Inflation peak = 11.1 Repo rate peak = 9.0 Current inflation= 9.7 Repo rate = 8.5 Repo rate, % 10.00



Feb-07 Oct-07 Jun-08 Feb-09 Oct-09 Jun-10 Feb-11 Oct-11

Source: RBI, Ministry of Industry

Chart 2: Key contributors of core inflation

Category-wise Apr to Sep 2011 Basic Metals, Alloys and Metal Products Average Contribution % Average Inflation %, yoy

Core inflation remains stubborn Core (non-food manufacturing) inflation, which indicates demandside pressures, has remained above 5 per cent in 5 out of past 7 years, much above RBIs comfort level. Despite a moderation in private consumption in the recent months, demand remains robust. This has enabled higher pass-through of rising global commodity prices and increasing interest costs into consumer prices. If demand-side pressures on inflation have to be tamed, core inflation needs to come down to around 4-5 per cent and remain there. This has not happened so far.
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Chemicals & Chemical Products Textiles

12.0 7.3

22.7 21.3

8.0 13.0 8.1

Rubber & Plastic



Source: Ministry of Commerce and Industry, CRISIL Research

Chart 3: Rupee and global crude oil price movements

US$ per barrel 115.0 49.2 Crude oil, WTI Exchange rate
Re per US$

Additional pressures from rupee are mounting A transitory risk to inflation has risen from a depreciating rupee which is pushing up import costs. The rupee fell by 11.1 per cent (April to October 2011), averaging at 49.3 to a dollar in October. Although commodity prices, especially that of crude oil, have fallen sharply since April 2011, they remain higher than a year ago. At the same time, the sharp depreciation of rupee, since August 2011, seems to have offset the gains from this decline in crude oil prices.





A falling rupee has also pushed up prices of non-administered fuel categories, such as aviation turbine fuel, bitumen and naptha, which are continuously exerting direct (first round) and indirect (second round) pressures on overall inflation.


44.4 Dec-10 Feb-11 Aug-11 Jun-11 Oct-10 Apr-11

74.0 Oct-11


We believe that this is largely a temporary phenomenon as rupee is expected to appreciate from the current lows, by March-end.

Source: RBI, CRISIL Research

What can bring inflation to 7 per cent by March 2012? Food inflation has been on a sustained decline, and for the current year so far has averaged at 8.5 per cent much lower than the 12.9 per cent average in the past two years. With good monsoons, pressures from food inflation are likely to moderate further. Global commodity prices are on a declining trend and we do not expect much upside in view of slowing global demand. Accordingly, there could be lower pressures to pass-through global prices into domestic economy. Some decline in inflation is evident from the month-on-month seasonally adjusted data. As per this series, inflation started its a sequential decline from April 2011, except in September when there was some pick-up.

Table 1: Inflation momentum

% 17.0

SA, q-o-q annualised 3 MA


5.0 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11

Source: Ministry of Statistics, CRISIL Research

Savings rate deregulation to intensify competition; larger banks relatively well placed The RBIs move to deregulate savings account deposit rates comes soon after its May 2011 directive to increase the interest rates offered on savings deposits from 3.5 per cent to 4 per cent. While deregulating savings account deposit rates, the RBI has also attempted to protect consumer interests by mandating that there should not be any discrimination between customers on interest rates for similar deposit amounts. CRISIL Research believes that freeing up savings account deposit rates will intensify competition among banks to garner a higher share of the low-cost deposits pie. Savings account rates are likely to inch up towards short-term deposit rates in the mediumterm, which are currently 200-300 basis points higher than the mandated savings account interest rate. Since savings accounts constitute about 23 per cent of total deposits of the banking system, a rise in deposit rates for these would accentuate pressure on banks net interest margins (NIMs). To compensate for the rise in cost of deposits, banks may impose additional charges for providing various facilities on savings accounts. Savings accounts are generally sticky. Depositors may be reluctant to shift accounts to other banks for a slightly higher interest if the existing bank offers better facilities and convenience. We believe that larger banks are relatively well-positioned on this front due to their strong customer relationships, superior reach, ability to cross bundle products and technological superiority.
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Chart: 4: Growth in credit and deposits

Deposit growth 30% 25% 20% 15% 10% 5% 0% Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Credit growth

Deposit growth to be robust at 18 per cent by March 2012 The cumulative rise in deposit rates in the first quarter of 201112, and a correction in capital markets, drove up deposit growth to 17.5 per cent as on October 7, 2011 from 16.0 per cent as on March 25, 2011. With an easing liquidity situation and slower credit off-take, CRISIL Research does not expect deposit rates to rise further over the next two quarters. CRISIL Research expects overall deposits growth to remain strong at about 18 per cent for 2011-12, stimulated by term deposits.

Source: RBI, CRISIL Research

Table 2: Sector-wise bank credit growth

(Growth, y-o-y %) Personal loans Iron & iron products Infrastr -ucture

Credit growth to moderate to 17 per cent by March 2012 Aggregate y-o-y bank credit growth moderated to 19.6 per cent as on October 7, 2011 from 21.6 per cent on March 25, 2011, due to slowdown in economic growth and rising interest rates. Credit growth in industries such as construction, infrastructure, especially telecommunication, and petrochemicals has decelerated sharply. Fresh corporate investments have come down to a trickle. They are expected to continue to remain sluggish until the macroeconomic environment improves. CRISIL Research therefore expects credit growth to moderate further to about 17 per cent by March 2012 due to a slowdown in investment growth. With the additional 25 bps hike in repo rate, banks cost of funds will rise further. However, sluggish credit demand and the limited ability of banks to pass on the increase in cost of funds would pull down their net interest margins by 15-20 bps in 2011-12.




1QFY10 2QFY10 3QFY10 4QFY10 1QFY11 2QFY11 3QFY11 4QFY11 1QFY12 Aug 11

21.2 17.9 15.7 20.1 25.8 29.2 27.4 23.6 22.0 23.6

20.5 11.0 11.5 15.0 14.1 21.0 25.0 23.9 20.9 20.6

5.5 2.3 -0.4 4.7 6.5 8.9 13.4 17.0 17.3 15.7

8.3 9.3 9.2 12.7 18.6 16.7 17.0 19.2 20.3 18.9

29.9 23.2 21.3 23.9 26.2 26.5 28.2 28.0 21.0 30.9

35.1 44.7 43.2 42.3 44.3 55.0 43.1 38.6 30.2 23.0

Note: Financial year Source: RBI

Chart 5: CD and Incremental CD ratios

Credit-deposit ratio Incremental credit-deposit ratio

Incremental credit-deposit ratio to fall to 70-75 per cent by March 2012 With a moderation in credit off-take due to higher interest rates, and a relatively higher growth in deposits, the incremental credit-deposit ratio declined to 81.2 per cent on October 7, 2011 from 97.2 per cent on March 25, 2011. As this scenario is likely to continue, CRISIL Research expects the ratio to stabilise at 70-75 per cent by March 2012.

120% 100% 80% 60% 40% 20% 0% Sep-09 Source: RBI Mar-10 Sep-10 Mar-11 Sep-11

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Macroeconomic Outlook 2 c 2011-12

Param meter
Growth (%) h Agriculture Industry y Services s Total GD DP Inflatio on Interes Rate st Exchan Rate nge Fiscal d deficit
Source: CRISIL Research

201 11-12
3.2 3 6.5 6 9.2 9 7.6 7 9.1 9 8.3 3-8.5 45.0 0-46.0 5.2 5

WPI Ave erage 10-year G-sec (Year-en nd) Re/US$ (Year-end) Fiscal Deficit (as a % of GDP) f

Contac cts:
Dharmakir Joshi rti Chief Econ nomist Email : djo oshi@crisil.com Phone: +91-22-3342 8034 Ajay Srinivasan Head d Email: ajsrinivasan@ @crisil.com Phone: +91-22-3342 3530 Dipti Saletore Economist Email: dsaletor re@crisil.com Phone: +91-22-3342 8019

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