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RBI cuts CRR to balance growth and inflation - Outside View by PersonalFN
 
 
RBI cuts CRR to balance growth and inflation

With gloomy clouds of debt-overhang situation in the Euro zone being evident, and intensifying since second quarter review of monetary policy 2011-12 (held on October 25, 2011), the Reserve Bank of India has once again pressed the pause button in its monetary policy action, thus keeping policy rates unchanged as under:

  • Repo rate at 8.50%; and

  • Reverse Repo rate at 7.50%
Thereby, maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points, and Marginal Standing Facility (MSF) rate at 9.50%.

However ascertaining the fact that liquidity has tightened further beginning the second week of November 2011 - partly due to Reserve Bank's forex market operations and advance tax outflows around mid-December 2011, the central bank has effected a reduction of 50 basis points (bps) in the Cash Reserve Ratio (CRR) , (with effect from the fortnight beginning January 28, 2012) thus reducing it from 6.00% to 5.50%.

[PersonalFN expected policy rates (both repo as well as the reverse repo) to be unchanged, along with status quo on CRR].

But the Statutory Liquidity Ratio (SLR) has been kept unchanged at its last reduced level of 24% (In the third quarter mid-review of monetary policy 2010-11 on December 16, 2010, SLR was reduced from 25% to 24%).

Bank rate too has been left unchanged at 6.00%.

Hence if we assess, after bringing in 13 successive increases since March 2010 to tame the inflation bug at the cost of economic growth, the central bank is now delicately trying to poise balance between domestic economic growth and inflation; given a highly uncertain economic environment still prevailing. It is noteworthy that this is the second successive time the central bank has turned the pause button for policy rates, and this time addressing to the tight liquidity situation prevailing has also effected a CRR cut (of 50 bps).

Policy Rate Tracker
  Increase / (Decrease) since March 2010 At present
Repo Rate 375 bps 8.50%
Reverse Repo Rate 425 bps 7.50%
Cash Reserve Ratio (50 bps)w.e.f. Jan 28, 2012 5.50%
Statutory Liquidity Ratio (100 bps) 24.00%
Bank Rate Unchanged 6.00%
(Source: RBI, Personal FN Research)

Reasons for this monetary policy action:
  • Gloomy global economy

    While there are modest signs of improvement in the U.S. economy (with a Q3 2011 growth of 1.8%), the gloomy clouds of debt overhang situation in the Euro zone are still evident. The recent European Union (EU) Summit too did not manage to assuage negative market sentiments, thus leading to financial turbulence to persist across both - developed and emerging market economies. In the EU summit while the European leaders did agree on a new fiscal compact, involving stronger coordination of economic policies to strengthen fiscal discipline, the medium and long-term sustainability of the Euro zone to resolve the short-term funding pressures was questioned by markets. Moreover, Q3 2011 growth (of 0.8%) in the Euro zone has been anemic and 2012 growth is now expected to be weaker than earlier projected. And interestingly reflecting these projections, the European Commercial Bank (ECB) has cut its policy rates twice in the last two months, and has also implemented some non-standard measures. Sovereign debt concerns in the euro area pose a major downside risk to overall growth outlook. The absence of a credible solution to the euro area problem is weighing on global growth prospects. Amongst the Emerging Market Economies (EMEs), China's growth too has slowed down to 8.9% in Q4 of 2011 (from 9.1% in Q3 and 9.5% in Q2); Brazil also has slowed on economic growth rate to 2.1% in Q3 (from 3.3% in Q2) and in South Africa to 3.1% from 3.2%. Growth in Russia, however, accelerated to 4.8% in Q3 from 3.4% in Q2 of 2011.

  • Headwinds in the domestic economy

    WPI inflation

    The drop in December 2011 WPI inflation (data released on January 16, 2012) to a 24 month low of 9.11%, mainly due to softening in food inflation (-2.90% for the week ended December 31, 2011) also encouraged the Reserve Bank of India (RBI) to maintain a status quo in policy rates, as it signaled moderation in WPI inflation. The momentum indicator of WPI, as measured by the seasonally adjusted 3-month moving average inflation rate, also showed a decline.

    Thus also keeping in view the expected moderation in non-food manufactured products inflation, domestic supply factors and global trends in commodity prices, the baseline projection for WPI inflation has been retained by the central bank at 7% as set out in the second quarter review of Monetary Policy 2011-12.

    Inflation bug crawling down!
    (Source: Office of Economic Advisor, Personal FN Research)

    We think that it would be interesting to see how the inflation chart takes shape in the ensuing months. This is because primarily the drop in WPI inflation is a "statistical effect"- high base effect, which may fade in the ensuing months. Also, although food inflation has dropped -2.90% for the week ended December 31, 2011 it is merely due to high base effect along with seasonal factors.

    Moreover, crude oil prices escalating are a worrisome factor. If oil marketing companies, take a cohesive decision with the Government to increase fuel prices to correct their under-recoveries it could prove to have a detrimental impact on overall inflation. Developments taking place globally need to be closely monitored as tensions prevailing between Iran and the U.S. could drive up the oil prices exponentially due to supply constraints imposed on account of closure of Strait of Hormuz, a vital transit route for almost one-fifth of the oil traded globally. The impact could be immediate and as such oil prices may skyrocket by 50% or more within days. Also with the Indian rupee lingering over Rs 50 per U.S. dollar mark, the risk of "imported inflation" creeping in still persists.

    Also, the fiscal deficit of the government has remained elevated since 2008-09. If the increase in Government borrowing already announced is an indication, the gross fiscal deficit for 2011-12 will overshoot the budget estimate substantially. At this current juncture when there is a need to boost private investment, the increase in fiscal deficit target (to Rs 4.7 trillion) could potentially crowd out credit to the private sector. Moreover, slippage in the fiscal deficit has been adding to inflationary pressures and it continues to be a risk for inflation.

    (Personal FN's forecast for inflation range is 7.00% - 7.50% by March 2012)

    GDP growth rate

    The deceleration in the economic growth rate consecutively in the last five quarters of the current fiscal year also encouraged the RBI to be accommodative. India's economic growth for the second quarter of the fiscal year 2011-12 has fallen to a 2-year low of 6.9% from 7.7% clocked in the previous quarter of the fiscal year, due to volatility in industrial growth. It is noteworthy that although after plunging to a -4.7% in October 2011, the IIP has posted a +5.9% growth in November 2011; however over the year, for the period from April 2011 to November 2011 the IIP has witnessed a slowdown to +3.8% (from +8.4% a year ago)

    Liquidity conditions

    Liquidity conditions have remained tight beyond the comfort zone of the RBI. Although the central bank did conduct open market purchase of Government securities to inject liquidity of over Rs 700 billion, the structural deficit in the system has increased significantly, which could hurt the credit flow to productive sectors of the economy. Thus addressing to large structural deficit in the system, the central bank has presented a strong case for injecting permanent primary liquidity into the system.
The stance of RBI's monetary policy action is intended to:
  • Maintain an interest rate environment to contain inflation and anchor inflation expectations

  • Manage liquidity to ensure that it remains in moderate deficit, consistent with effective monetary transmission

  • Respond to increasing downside risks to growth
RBI's GDP estimate:

Based on the current and evolving macroeconomic situation, the RBI's growth projection for the Indian economy has been revised to 7.0%, from 7.6% set out in the 2nd quarter review of monetary policy 2011-12 (held on October 25, 2011) due to:
  • Increase in global uncertainty

  • Weak industrial growth

  • Slowdown in investment activity

  • Deceleration in the resource flow to commercial sector
We believe that the growth rate projected by the RBI looks achievable as the monetary policy actions undertaken earlier to control inflation may hamper India's GDP growth rate. Moreover with global risk prevailing, a growth rate below 8.0% looks more probable.

What does the policy stance mean and its impact

The repo rate is the rate of interest charged by the central bank on borrowings by the commercial banks. Keeping it unchanged means, there are unlikely chances of an increase in borrowing cost of commercial banks. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may remain unchanged, as the commercial banks in the country too may maintain a status quo.

Similarly, the interest rates on fixed deposits are expected to remain firm until further monetary policy action. At present 1 yr FDs (Fixed Deposits) are offering interest in the range of 7.25% - 9.40% p.a.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Keeping them unchanged will result in commercial banks continuing to enjoy the same interest rates as earlier, for parking their surplus funds with RBI.

The Cash Reserve Ratio is the amount of amount of liquid cash which the banks are supposed to maintain with RBI. Reducing the same would ease the liquidity in the system, which had been tight since November 2011.

The Statutory Liquid Ratio (SLR) is the amount that the commercial banks require to maintain in the form of cash, or gold or govt. approved securities before providing credit to the customers. Keeping them unchanged would not hurt the tight liquidity situation.

Guidance from monetary policy and path for interest rates

In reducing the CRR, the Reserve Bank has attempted to address the structural pressures on liquidity in a way that is not inconsistent with the prevailing monetary stance. In the two previous guidances, it was indicated that the cycle of rate increases had peaked and further actions were likely to reverse the cycle. Based on the current inflation trajectory, including consideration of suppressed inflation, it is premature to begin reducing the policy rate. The reduction in the policy rate will be conditioned by signs of sustainable moderation in inflation. Moreover, it is emphasised that the timing and magnitude of future rate actions is contingent on a number of factors.

What should Debt fund investors do

We believe that the current situation is attractive to take exposure to debt mutual fund instruments as interest rates are likely to consolidate at these higher levels before they start going down.

You can now gradually take exposure to pure income and short-term Government securities funds. Since longer tenor papers will become attractive, longer duration funds (preferably through dynamic bond / flexi-debt funds) can be also considered, if one has a longer investment horizon (of say 2 to 3 years). However, one may witness some volatility in the near term as there is always an interest rate risk associated with the longer maturity instruments.

With liquidity in the system being tight, yield on the short term instruments is expected to remain high thus making short-term papers attractive. Hence investors with a short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 month or liquid plus funds for next 3 to 6 months horizon. However, investors with a medium term investment horizon (of over 6 months), may allocate their investments to floating rate funds. Short term income funds should be held strictly with a 1 year time horizon.

Fixed Maturity Plans (FMPs) of 3 months to 1 year will yield appealing returns and can also be considered as an option to bank FDs only if you are willing to hold it till maturity, but you may not have a very attractive post tax benefit, as indexation benefit will not be available on FMPs maturing within 2 months. You can consider investing your money in Fixed Deposits (FDs) as well; at present 1 year FDs are offering interest in the range of 7.25% - 9.40% p.a.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

 

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