Monetary policy – it’s a turn for sure, BUT no U turn as yet!

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?

Annual Monetary Policy 2008-09

Highlights
- Bank rate, reverse repo rate and repo rate kept unchanged
- Following a CRR hike by 50 bps on April 17, the ratio hiked by further 25 bps to 8.25%, with effect from the fortnight beginning May 24. This cumulative hike of 75 bps is expected to suck out liquidity worth Rs 277.5 billion
- Survey on GDP growth for 2008-09 in the range of 8.0-8.5%
- Inflation target raised from 5 to 5.5%, with a medium-term objective of 3.0%
- M3 growth to be contained within the range of 16.5-17.0%
- Deposits projected to increase by around 17%
- Growth of non-food credit to be contained around 20%
- The limit of bank loans for housing enhanced from Rs 20 lakhs to Rs 30 lakhs for applicability of reduced risk weights at 50%
- Indian companies allowed to invest overseas in energy and natural resources sectors such as oil, gas and coal in excess of the current limits

RBI Governor Yaga Venugopal Reddy is known to often surprise the market and the annual policy review this time around showed him being true to form again with his decision to raise the cash reserve ratio for the third time without touching key policy rates.

The Monetary Policy of 2008-2009 comes in the backdrop of a slowing economy facing a sudden and a sharp surge in inflation. The WPI-based inflation touched 7.41% in March way above the virtual roof (RBI’s comfort zone of 5 per cent). The growth moderating effects of tight monetary policy over the last two years are still coming through and a moderating global economy is reducing the external stimulus to growth. Also, the inflationary surge is largely because of higher food, metal and energy prices. This is creating strong supply side (cost-push) inflationary pressure on the economy with significant threats to growth.

As monetary tightening is more effective in controlling demand-driven inflation, the central bank faces a difficult choice of balancing downside risks to growth along with upside risks to inflation. In our April 2 note (“Inflation: through the roof – way forward?”) we forecasted the inflation number to hover in the range of 7-7.5% and for last four weeks it has. We expect inflation figure to slow down due to the fiscal measures taken on supply side along with further tightening of money supply in the range of 6-6.5% for next few weeks, and to be in the range of 5.5-6% until June’08.

Money is the ultimate commodity because all prices have only money in common. And it is the only thing that a central bank directly controls. With increase in CRR by 75bps in three fortnights, would force banks to reduce their short-term deposit rates to contain their borrowing cost and to protect their margins. Such action would also impact the deposit growth contain M3. As of the aggregate deposits mustered banks are required to park 25% of their net demand and time liabilities in SLR securities and 8.25% of as CRR balances with the RBI. Only the balance 66.75% of total deposits along with the borrowings, are available for deployment towards advances. If lending rates and the yield on investments remain constant, SCBs as a whole have had to take a hit of 7 bps (annualised) on their spreads and net profitability margin solely due to CRR increases.

The move enhancing the limit of housing loans from Rs 2 million to Rs 3 million is a positive one and may partly help in addressing the current slowdown in housing loan disbursements. The enhancement of loan limit will, positively impact the capital adequacy of banks, with a 25% savings in capital charge. This measure might indirectly create a cushion of margin money in the event of a likely fall in property prices.

Policy document says, “It is critical at this juncture to demonstrate on a continuing basis a determination to act decisively, effectively and swiftly to curb any signs of adverse developments in regard to inflation expectations”.

Though most of the inflationary pressure is imported and not necessarily due to supply shortage. Mostly due to soaring commodity prices in global market due to weakening dollar, as most of the commodities are denominated in dollar. Such impact is clearly visible in crude oil prices, world oil demand grew by just 1% annually over the past two years while crude oil prices had shot up by over 90% in dollar terms, hitting $120 a barrel. Over 70% of the price rise in just few months, oil was at $70 in late August.

According to Wall Street Journal, since 2003 the dollar price of oil has climbed far more rapidly than has the euro price – 273% in dollars, compared to 146% in euros. Had the dollar merely retained the same purchasing power as the euro, today's price of oil would be below $70 a barrel.