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Monetary Policy: Stance unchanged!

Jan 25, 2006

The quarterly review of the monetary policy, declared yesterday, once again reaffirmed the stance of monetary policy set out in the Annual Policy Statement. While on one hand retaining the outlook on inflation and credit growth, the apex bank also highlighted the risks that had emerged - credit quality concerns, rising asset prices (especially housing), high and volatile international crude prices, the widening trade deficit and the upturn in the international interest rate cycle. Consistent with this stance, the Reserve Bank of India (RBI), in tune with its commitment of ensuring a conducive interest rate environment and appropriate liquidity to meet the credit needs of the economy, once again raised the reverse repo and repo rates by a quarter percentage point each (Repo - 6.5%, Reverse repo - 5.5%), having executed the same measure in the mid term review. While the same seems to be trailing the uptick in the Fed funds rate, containment of inflationary pressures due to any liquidity overhang does not seem to be the regulator's mission.

The RBI's take on the economy...

  • The pick up in growth of real GDP to 8.8% during 1HFY06 as against 8.3% in the corresponding period of FY05, was on the back of sustained growth in industrial activity and resilience to slowdown in the performance of the infrastructure activities.

  • The index of industrial production (IIP), however, rose by 8.3% until November 2005, a tad lower than 8.6% in the corresponding period of the preceding year.

  • Inflation, measured by the consumer price index (CPI), softened to 4.2% at the end of November 2005 against 5.3% a year ago.

  • Money supply (M3) expanded by 13% YoY upto December 2005 against 9% in the previous year, thus manifesting the liquidity overhang that existed. Nevertheless, the IMD redemptions and continued credit growth demand have sucked out a large part of surplus funds from the economy.

  • The interest rates on deposits accepted by banks moved up by an average of 50 basis points driven by liquidity constraints and necessity to attract relatively lower cost funds. Deposit growth (net of conversions) was also higher at 17% YoY until December 2005, higher than 15% in the previous year.

  • While the median lending rates for private sector banks remained in the range of 10.25% to 11.25%, that for their PSU counterparts moved up by a quarter percentage point given the margin pressures. A larger part of the rate revision was in the case of sub PLR rates for corporates.

  • Non-food credit growth was at a high of 32% YoY despite the high base effect of 9mFY05. Bank credit to the services sector increased by as much as 21%, accounting for 59% of the incremental non-food credit. The growth in credit to the services sector was led by housing, commercial real estate and personal loans, which together accounted for over a third of incremental non-food credit in 9mFY06.

In the aftermath of the rate hike...
Even as there are concerns with respect to liquidity (despite RBI's intervention), the demand for money in the domestic market is buoyant. Almost 30% growth in credit-offtake is high by any standards. Theory suggests that when demand is higher than supply, interest rates are likely to harden. But the RBI adopted a 'wait and watch' approach till yesterday and therefore, interest rates were maintained. The upward revision of interest rates was on the horizon and yesterday's announcement is not surprising (though the Finance Minister does not seem to be pleased with the same). While banks have already taken the hit of higher cost of funds on their margins, the tightening of liquidity will necessitate passing on the rate hike to consumers. While this will on one-hand ease pressures on the sector's margins, it will also dissuade 'generous' disbursement of credit. Besides, the measure is expected to check inflationary concerns in the medium term, even if foreign funds keep flowing in. Seems that the RBI is doing a good job!

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