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  • APRIL 28, 2005

Monetary Policy: Wait and watch for now!

The Reserve Bank of India (RBI) has announced its Annual Monetary Policy for the year 2005-06. Despite concerns regarding faster increase in interest rates in key global economies and commodity prices continuing to trade firmly, the benchmark interest rates has been left untouched at 6.0%. The cash reserve ratio (CRR) has also been maintained at 5.0%.

The stance of this monetary policy...
As always, price stability is one of the key objectives of the monetary policy. Higher GDP growth amidst rising prices of goods can lead to runaway inflation and tends to have a negative impact on the economy over a period of time. Given the fact that prices of oil and other commodities have been ruling firm in the global markets, there are concerns on the inflation front, which is the RBI is faced with. In the Monetary Policy, the RBI has mentioned that "the outlook for growth (read GDP growth) in 2005-06, may get moderated by the conditions in oil markets, which remain tight”.

In this backdrop, the RBI's stance remains that of 'equal emphasis on price stability' and 'provision of appropriate liquidity'.

Though the RBI has left the benchmark interest rate untouched for now, there are more reasons to believe that it may rise in the future.

  1. Prices still higher: Commodity prices continue to trade higher. Though there has been a decline in the recent past, on a YoY basis, there is a significant increase. The RBI expects wholesale inflation in the range of 5.0% to 5.5% in FY06 (average of 5.0% in FY05).

  2. How long can oil companies bear it? While the rise in prices of steel, aluminium and other related commodity have been mostly passed to the manufacturers, at the retail level, it is not fully reflected. This means that manufacturers have absorbed most of the cost escalation and this explains the margin pressure in FY05. Secondly, the government has not increased prices of petroleum product prices at the retail level owing to political compulsions. So, the consumers have been protected noticeably. This can be explained from the fact that as compared to the average inflation at the wholesale of 5.0% in FY05, inflation at the retail level stood at only 3.1%. How long can corporates absorb the impact and how long can oil companies withstand losses is anybody's guess. But if price increases were to happen at the retail end, inflation will start climbing.

  3. Everybody is borrowing! In the Budget for 2005-06, the Finance Minister envisaged a marginal increase in fiscal deficit as a percentage of sales. While the Monetary Policy expects India's GDP to grow at 7.0% in FY06, the fact that higher fiscal deficit will result in increased government borrowing from the market is a reality. Simultaneously, demand for credit from corporates is also increasing (non-food credit growth in FY05 was 26.5%, of which 40% is constituted by housing loans). This is in total contrast before three years when corporate demand was sluggish. Since the appetite for credit is growing on a much broader scale now, if liquidity comes under pressure, there will be an upward pressure on interest rates.

  4. Interest rates are rising globally: The US Federal Reserve is expected to meet again next week and it is expected that there will be a hike in interest rates yet again. While we are getting into the 'how much' debate, recent releases of the past Federal Reserve Governors meet paint a mixed picture. If interest rates in the global market rise faster, the portfolio investment flow into developing economies like India may be affected in the medium-term. This again impacts liquidity.

As the Monetary Policy reads "barring the emergence of any adverse and unexpected developments in various sectors of the economy and keeping in view the inflationary situation, the overall stance of monetary policy for the year 2005-06 will continue to be as set out in the mid-term Review of October 2004, namely:

  • Provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy while placing equal emphasis on price stability.

  • Consistent with the above, to pursue an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the momentum of growth.

  • To consider measures in a calibrated manner, in response to evolving circumstances with a view to stabilising inflationary expectations”.

Overall, the RBI seems to have opted for a 'wait and watch' approach for now. What should equity investors do at the current juncture? For now, there is nothing significant to start worrying about. But one has to acknowledge the fact that there are risks. If interest rates go up, it will affect equity prices and sooner or later, corporates will feel the pinch (not the top rungs).

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