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  • Oct 27, 2009 - RBI's monetary policy: And the dilemma continues...

RBI's monetary policy: And the dilemma continues...

Oct 27, 2009

In what would bring some cheer to borrowers - individuals, corporate, and the government - the RBI decided to keep its key interest rates unchanged as it announced its mid-term review of the monetary policy for 2009-10 a short while ago. However, the central bank hiked the statutory liquidity ratio (SLR)* to 25% from 24%, thereby sending out initial signals towards raising interest rates in the future. But that will depend on whether the inflation continues to rise the way it is doing now, and the economic momentum continues to pick up pace. In fact, going by the RBI's upward revision of target inflation by March 2010 end to 6.5%, from 5% earlier, it seems clear that the bank's next step will be towards higher interest rates. And the markets seemed to be fearing just that given that the BSE-Sensex has crashed after Dr. Subbarao, the RBI governor, made clear his intentions through the policy documents some time back.

Real estate stocks are the worst hit as of now, as the BSE-Realty Index has crashed by around 6%. This is given that the RBI has indicated its worry about rising property prices by increasing the provisioning requirement for advances to the commercial real estate sector from 0.4% to 1%. This is surely going to hit realty companies that are looking to borrow from the banks to fund their commercial real estate development plans. Not only will the RBI's SLR move action make it difficult for realty companies to get sufficient loans, the higher provisioning norms will also likely raise their interest costs on such loans.

As the RBI rightly states - "In view of large increase in credit to the commercial real estate sector over the last one year and the extent of restructured advances in this sector, it would be prudent to build cushion against likely non-performing assets."

Anyways, here are the RBI's views on inflation, GDP, and credit growth as outlined in the policy document.

Inflation - Expected to surge higher
As indicated above, the RBI has also made clear its worries about rising inflation on the back of rising food prices. The consumer price inflation (as per the CPI or consumer price index) currently stands at around 11.7%, the highest among key developed and developing countries. And this surely has the government and the RBI worried. This is given that the current inflation is largely driven by higher food prices (which directly impacts consumers) as against the high inflation of 2008, where massive rise was seen in prices of metals and crude oil. Now with agricultural production estimated to be lower for the full year 2009-10, inflationary pressures are only expected to intensify.

Note: Data is for CPI of industrial workers; Data Source: RBI

GDP growth - Estimates maintained
On an overall basis, assuming a modest decline in agricultural production and a faster recovery in industrial production, the RBI has maintained its 2009-10 GDP growth estimates at 6%

Credit demand - Unlikely to pick up pace soon
The RBI has indicated that money supply within the economy has increased from 18.6% in end-March 2009 to 18.9% by October 9, 2009. A large part of this growth was on account of the banking system's financing of the large market borrowing of the government. In contrast, growth in bank credit to the commercial sector has moderated significantly to 10.7% from the high level of 27.4% a year ago indicating the cautious approach of Indian companies (excluding, of course, the realty companies!).

Now, keeping in view the borrowing requirement of the government and of the commercial sector in the remaining period of 2009-10, the RBI has lowered its full year money supply growth target from 18% (set out in July 2009) to 17%. More importantly, the RBI has urged banks once again to step up their efforts towards credit expansion while preserving credit quality which is critical for revival of growth.

RBI's overall view - Status quo as of now
RBI believes that there has been a visible improvement in the global economic outlook since July 2009 and the same is seen in India as well. Accordingly, it clarifies that attention around the world, as also in India, has shifted from managing the crisis (by looking to cut and maintain interest rates at lower level) to managing the recovery (by trying to ward off rising inflation).

The RBI has also reiterated its dilemma whether to wait or start raising interest rates soon. The dilemma is because if its waits, inflation can spiral out of control. And on the other hand, if it starts raising interest rates anytime soon, it might cut short a fledgling economic recovery. The RBI's confusion as it waits to start raising interest rates also stems from the rising borrowings of the government and therefore its rising deficit, which has the ability to cause high inflation in the future.

So, by not touching any of the key interest rates (like repo rate, reverse repo rate, bank rate, and CRR), the RBI has opted to wait and watch for now.

Read the complete monetary policy document

* SLR - As defined by Wikipedia, Statutory Liquidity Ratio or SLR refers to the amount that all banks require to maintain in cash or in the form of gold or approved securities with the RBI. The key objectives of SLR are to restrict the expansion of bank credit, augment the investment of the banks in Government securities, and ensure solvency of banks.

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