The Reserve Bank of India (RBI), in its mid term review of the monetary policy, made its best attempt to realign the Indian economy with global trends. Spiraling economic growth, a yawning current account deficit, inflationary pressures and the rupee depreciation (to 11-month lows) certainly made a strong case for the rate hike. But above all, the apex bank seems to have been compelled to fall in line with the Fed's 'measured' approach to stop the flight of foreign money to their parent destinations.
Nevertheless, what the apex bank largely emphasized on in the credit policy were its policies for the country's banking sector:
Rate hike: While most bankers see the dual rate hike (in repo and reverse repo) as the ideal means to suck liquidity, they also opine that the same has triggered the reversal in interest rate trends. In fact, banks that have been facing margin pressures for a couple of quarters now have already signaled an up-tick in lending rates (especially to the AAA corporates), without tinkering with the benchmark PLR (prime lending rate). However, at the same time, the possibility of the AAA corporates arm-twisting banks for higher deposit rates (on bulk deposits) cannot be ruled out. We reckon that margins (NIMs) for the sector will continue to remain under pressure in the medium term.
Restriction of capital market exposure: The RBI proposed to restrict banks' aggregate capital market exposure to 40% per cent of their net worth, as against the earlier restriction of 5% of advances or 20% of net worth, whichever was higher. While this provided additional headroom to certain banks, it was also a prudent measure, considering that net worth is the most appropriate benchmark of a bank's risk taking ability.
Higher provisioning on standard advances: Traditionally, banks' advances portfolio is cyclical and tends to grow faster during an expansionary phase than during a recessionary phase. During times of expansion and accelerated credit growth, there is a tendency amongst banks to underestimate the level of inherent risk. Recognising this risk and foreseeing the possibility of higher incremental slippages, the RBI proposed to increase the general provisioning requirement for 'standard advances' from the earlier level of 0.25% to 0.4% per cent.
Treatment of IFR as Tier-I capital: Banks that maintain the minimum stipulated 9% CAR would be permitted to treat the entire balance in the investment fluctuation reserve (IFR) as Tier-I capital. Once the amount of IFR is so transferred towards Tier-I capital, headroom for raising an equal amount of Tier II capital would become available to the eligible banks, up to half of which could be raised through issuance of subordinated debt.
The central bank also outlined its future outlook for the sector:
Money supply (M3) has increased by 9.6% YoY in the first half and the annual expansion is expected to be higher than the earlier projection of 14.5%.
Aggregate deposit growth is also expected to be higher than Rs 2,600 bn projected earlier
Non-food credit that grew at an unprecedented pace of 27.8% YoY in 1HFY06 as compared with 21.4% in 1HFY05 is expected to largely outstrip the target of 19% projected earlier.
Although the growth in non-food credit has been broad-based, the credit offtake witnessed a structural shift towards the non-agricultural and non-industrial sectors in recent years. Also, the growth in non-agricultural non-industrial sector was led by housing, real estate and personal loans. The apex bank thus categorically stated that the high non-food credit growth, while on one hand remains overexposed to certain pockets of retail credit, the share of credit to infrastructure remains low relative to the size and state of the economy.
Inflation is low in terms of commodity prices but asset prices, especially housing prices, have registered a substantial increase. Asset price changes continue to pose a challenge for the economy, as it can have a powerful effect on investment and/or consumption through a financial accelerator effect.
To sum up, in its latest dialogue, not only did the central bank finally change its stance of monetary policy, but also appreciably put forth its anticipations and apprehensions about the country's financial sector.