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Monetary policy: Will CRR cut usher in growth? - Views on News from Equitymaster

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Monetary policy: Will CRR cut usher in growth?
Jan 24, 2012

In its third quarter review of monetary policy, the Reserve Bank of India (RBI) decided to cut the cash reserve ratio (CRR) by 0.5% bringing it to 5.5%. This move is expected to ease liquidity by injecting Rs 320 bn in the banking system. However, the repo rate (rate at which banks borrow from the Reserve Bank Of India (RBI)) was kept unchanged at 8.5%. Consequentially the reverse repo (rate at which RBI borrows from the banks) also remains unchanged at 7.5%.

In reducing the CRR, (share of deposits banks must hold with the central bank), the RBI has tried to ease the structural pressures on liquidity. The central bank had earlier stated that interest rates have peaked in the country. However it believed that cutting rates at this juncture would have been too premature. It believes that the CRR cut would be the most effective way to permanently inject liquidity in the system.

Economic situation

Globally the economic situation still remains tense. Mass rating downgrades has intensified the problem in the Euro zone. In the United States the economic situation is improving slowly, however growth still remains negligible. In India GDP growth rate has definitely taken a turn for the worse. Investment activity, especially, has declined due to policy bottlenecks and steep funding costs. However on the plus side inflation has seen some moderation in recent months. The Reserve Bank of India maintains its 7% inflation projection for March 2012. Headline wholesale price index (WPI) inflation, which averaged 9.7% (y-o-y) during April-October 2011, moderated to 9.1% in November 2011. It further fell to 7.5% in December 2011, continuing its downward trend. While food inflation has been in the negative for the past few weeks, this has mainly been due to a seasonal effect. A worrying sign is that non-food manufacturing inflation still remains high. Fuel inflation has also remained above comfort levels, especially on account of the acute rupee depreciation. Seeing non-food inflation as a major risk factor, the RBI has decided for the time being to hold base lending rates steady for the second time in a row .

Credit growth in the country has taken a turn for the worse, with most banks seeing a reduction in credit demand. While most banks have still managed to see some balance sheet growth this fiscal, most of this growth has come from existing sanctions. New sanctions have soured. The year on year (YoY) non-food credit growth came in at 15.7% by end December, 2011. This comes in well below the earlier projection of 18% for the year. This has also moderated sharply from the 21.3% YoY growth levels seen at the end of FY11. Consequently the RBI has scaled down its projection of non-food credit growth to 16%.

In India, GDP growth moderated from 7.7% 1QFY12 to 6.9% in 2QFY12 (July-September). This was mainly on account of the deceleration in industrial growth from 6.7% to 2.8%. Consequently, GDP growth during 1HFY12 slowed to 7.3% compared to 8.6% last year. In light of the very apparent slowdown the RBI has revised its growth target for the country in FY12 from 7.6% previously to 7%. Global uncertainty, weak industrial growth, and a slowdown in investment activity have all contributed to the slowdown. However, the bank expects some recovery in FY13 from current levels.

The way forward

With so much uncertainty looming ahead, its hard to predict what the next action for the central bank will be. Inflation seems to be on a downward trajectory, but credit growth and GDP is seeing a slowdown. The RBI has indicated in the past that rate cuts are not the only solution to curbing inflation and stimulating growth.

The RBI has also not been very forthcoming about when a policy rate cut will take place. It stated that the timing and magnitude of future rate actions depends on a number of factors. Most importantly policy and administrative actions, which will help remove supply bottlenecks in food and infrastructure. Skill development is also needed to narrow skill mismatches in labour markets will in turn ease the pressure on wages. The government also needs to focus on controlling its fiscal deficit. If not controlled, this can lead to higher inflation and economic instability. Now, the next thing on every investor's watch list is the upcoming Union Budget. We hope government plays its part in complementing the RBI's efforts in stimulating economic vitality.

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