• OCTOBER 25, 2011

Monetary Policy: Have interest rates finally peaked?

The Reserve Bank of India (RBI) declared its monetary policy review for the second quarter of the financial year 2011-12 today. High fuel prices coupled with rapid currency depreciation and persistent inflation forced the RBI to hike rates once again, for the 13th and possibly final time since March 2010.

The RBI raised the rates at which it lends to banks (repo rate) by 0.25%. Thus the repo rate now stands at 8.5% from 8.25% previously. The rate at which RBI borrows from banks (reverse repo) now stands 7.5% post the review. The central bank left the cash reserve ratio (CRR) unchanged at 6%.

The RBI was concerned that even with successive rate hikes, and slowing growth inflation continued to remain above its comfort levels. Inflation has remained persistently high, affecting the margins of companies and wallets of individuals. Thus the central bank decided that it was not yet time for it to roll back on its monetary tightening. However, if inflation moderates further rate hikes may not be necessary. Thus, the bank can then address concerns with regard to slowing economic growth and investments.

Tightrope between high inflation and a slowing economy

Headline inflation measured as Wholesale Price Index (WPI) has remained at an average rate of 9.6% so far this fiscal, continuing to remain stubbornly above comfort levels. Food inflation has remained high on account of increased food prices namely vegetables, milk and pulses. Fuel inflation has also remained high on account of the hike in petrol prices and the upward revision in electricity tariffs. Currency depreciation and higher crude prices globally are putting pressure on India's oil import bill.

Although supply side issues have made the RBI's rate hikes redundant in taming inflation so far, the central bank believes that the WPI will start falling from December 2011. In fact the WPI is expected to touch 7% by March 2012. However, it has not denied the fact that a lot of supply side challenges persist on the agriculture and infrastructure front.

The global economy has seen deterioration over the last quarter. There are renewed fears of recession on the back of the Euro sovereign debt crisis. A slowdown in the US economy is showing its effects. Emerging economies have also seen slower growth as the troubled developed nations are major trading partners. However, domestic demand from their large populations has led them to continue to see a decent pace of growth.

In India, GDP growth decelerated to 7.7% in 1QFY12 from 8.8% in 1QFY11. The Index of Industrial Production (IIP) slowed from 8.7% YoY in the April-August period to 5.6% currently. Business sentiment has also been waning and margins of corporate have declined. The government has also been facing the heat. It is expected to fall miserably short of its disinvestment target for the fiscal and has also increased its budgeted borrowings by over Rs 0.5 trillion.

The RBI has therefore revised its projection of India's FY12 GDP growth to 7.6% from 8% earlier on account of slower investment demand.

Savings account deregulation

Households have been struggling with high bank lending rates which have persisted above 9%. However, they are only able to recover 4% on their savings bank account. The RBI has thus decided to now deregulate the savings bank account rate in a landmark move. Banks are thus free to compete for savings bank account rates subject to two conditions:

  • Each bank will have to offer a uniform interest rate on savings bank deposits up to Rs 100,000 (1 lakh, irrespective of the amount in the account within this limit.
  • For savings bank deposits over Rs 100,000 (1 lakh), a bank may provide differential rates of interest, if it chooses to do so. There should not be any discrimination from customer to customer on interest rates for a similar amount of deposit.
We will be putting up a more detailed note on the same shortly.

The path forward

Since March 2010, the central bank has exited from its expansionary policy with a vengeance. This is the thirteenth rate hike orchestrated by the RBI. Cumulatively we have seen an effective tightening of 5.25% as inflation has been a major bug bear for over 2 years. Going forward the RBI needs to focus on addressing the concern of slowing growth in the economy.

Non-food credit growth has however still managed to rise. Although it decelerated from a 22.6% YoY growth in April to 19.3% in the beginning of October 2011, it still remains higher than the projection of 18% given by the RBI for FY12. Having said that, the 0.25% rate hike in September has still not been passed on by most banks. The latest rate hike may be a further dampener on credit offtake. Interest rate sensitive products like vehicles, housing etc are all expected to become more expensive. Plus companies may see further margin contraction. Banks' margins may also see a contraction in the near term on account of the savings bank rate deregulation which will increase their cost of funds for CASA (current and savings accounts).

Now there is hope that inflation will finally react positively to the RBI's monetary policy move, helping the central bank abandon its cautious stance on liquidity. However, the economy and the banking sector will continue to feel the heat of high funding costs in the near to medium term.

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