RBI governor would be announcing the outcome of quarterly monetary policy review this week. Street is in a fix and so are the policy makers as whether the time for the reversal of the easy monetary policy has come or not. Early reversal could impact the economic growth while prolonged easy policy has its consequences in form of inflation, and could be enabling asset price bubble formation. We are certainly out of the woods and see the path to higher growth; though the concern remains as an early withdrawal could send us back to where we were earlier. On one hand we are still way below our potential economic growth, exporting sector still in doll drums, manufacturing recovering but well below their full capacity utilization; in sum output gap is still wide open. On the other side of coin is the high and increasing inflation; CPI never saw single digit growth number for more than 18 months now; WPI is out in green from a short statistical negative zone. Year to date inflation in 2009 is far above than those in 2008; and the gap is expected to be widening every week, with the expectation of well above 7% by end of fiscal if easy policy continues.
Given the backdrop I expect RBI to take actions to contain inflationary expectations while continue to enable continuation of economic growth. Ideal move, but how would they do it? To contain inflationary expectation they would be reducing the excess liquidity from the system for sure (through increase in CRR, to begin with 50 bps). Let me remind you that the reversal of the monetary policy accommodation would be in big steps and not in small bits, remember the large steps they took while loosening the policy.
Step 1- Increase CRR by 50 bps, to continue until inflationary expectations fueled by the excess liquidity is contained. In my view, this would take about 150 bps increase in CRR rates over next 9 months.
Okay, but if you do that wouldn’t the recovery story suffer? Well may not be so, as they would also be reducing the repo and reverse repo rates to the magnitude of another 25 bps. Which will enable RBI to single continuation of low rate environment; and to incase credit flow in the system rather than parking funds with RBI under LAF. This would also help in taking the pressure off the G-Sec yield curve due to high government borrowing requirements.
Step 2- Reduce repo & reverse repo rates by 25 bps. Lower rates environment to continue until Feb next year; further course would be dependent on the Budgeted fiscal deficit for FY11.
That should work in containing inflationary expectations, while not choking the economic growth per se!!! If the rates were the concerns you had, you may stop reading further. No change in SLR requirements is expected as of now; though one percent reduction allowed may be rolled out. We are also expecting the withdrawal/non continuation of some of the temporary liquidity measures announce over the course of last one year, as they are no longer needed/utilized, e.g. liquidity facility for mutual funds etc.
This is not all what we are expecting from the monetary policy, we also expect some change in securitizations rules for the banking sector, banks may be asked to keep the securitized assets on their book for six months, and may not allowed to sell down entire bucket, to help in retaining credit balance. RBI wouldn’t want to make the mistakes of the developed world by creating junk securitized assets.
Step 3- Restrictions on securitization of assets in full & immediately, this would mean banking sectors fee income growth may see some decline.
Other policy measures would be in form of introducing the new Base rate system, some time away from now. We may also see some announcement in view of financial sector reforms by allowing foreign banks to enter Indian market freely. However, we are not expecting any significant change in the course of capital account convertibility or shall I say dual listing?