Monetary policy


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Monetary policy

  1. 1. Changes in monetary policy post 2007 RBI Annual Monetary Policy 2010-11 Repo rate and Reverse repo rate increased by 25 bps to 5.25% and 3.75% respectively, with immediate effect. Impact: Repo is the rate at which banks borrow from RBI and Reverse Repo is the rate at which banks deploy their surplus funds with RBI. Both these rates are used by financial system for overnight lending and borrowing purposes. An increase in these policy rates imply borrowing and lending costs for banks would increase and this should lead to overall increase in interest rates like credit, deposit etc. The higher interest rates will in turn lead to lower demand and thereby lower inflation. The move was in line with market expectations Cash reserve ratio (CRR) increased by 25 bps to 6.00%, to apply from fortnight beginning from 24 April 2010. Impact: When banks raise demand and time deposits, they are required to keep a certain percent with RBI. This percent is called CRR. An increase in CRR implies banks would be required to keep higher percentage of fresh deposits with RBI. This will lead to lower liquidity in the system. Higher liquidity leads to asset price inflation and also leads to build up of inflationary expectations. Before the policy, market participants were divided over CRR. Some felt CRR should not be raised as liquidity would be needed to manage the government borrowing program, 3-G auctions and credit growth. Others felt CRR should be increased to check excess liquidity into the system which was feeding into asset price inflation and general inflationary expectations. Some in the second group even advocated a 50 bps hike in CRR. By increasing the rate by 25 bps, RBI has signalled that though it wants to tighten liquidity it also wants to keep ample liquidity to meet the outflows. Governor’s statement added that in 2010-11, despite lower budgeted borrowings, fresh issuance will be around Rs 342300 cr compared to Rs 251000 cr last year. RBI’s Domestic Outlook for 2010-11 Table 1: RBI’s Indicative Projections (All Fig In %, YoY) 2009-10 targets 2009-10 2010-11 targets (Jan 10 Policy) Actual Numbers (Apr 10 Policy) GDP 7.5 Expected at 7.2 8 with an upward by CSO bias Inflation (based on WPI, 8.5 9.9 5.5 for March end) Money Supply (March 16.5 17.3 17 end) Credit (March end) 16 17 20 Deposit (March end) 17 17.1 18 Source: RBI Growth: RBI revised its growth forecast upwards for 2010-11 at 8% with an upward bias compared to 2009-10 figure of 7.5%. It said “Indian economy is firmly on the recovery path.” RBI’s business outlook survey shows corporate are optimistic over the business environment. Growth in industrial sector and services has picked up in second half of 2009-10 and is expected to continue. The exports and import sector has also registered a strong growth. It is important to note that RBI has placed the growth under the assumption of a normal monsoon. India could have achieved a near
  2. 2. 8% growth in 2009-10 itself, if monsoons were better. Table 2 looks at growth forecasts of Indian economy for 2010-11 by various agencies Table 2:Projections of GDP Growth by various agencies for 2010-11 (in %, YoY) 2009-10 2010-11 RBI 7.5 with an upward 8 with an upward bias bias PM’s Economic Advisory Council 7.2 8.2 Ministry of Finance 7.2 8.5 (+/- 0.25) IMF 6.7 8 Asian Development Bank 7.2 8.2 OECD 6.1 7.3 RBI’s Survey of Professional 7.2 8.5 Forecasters Inflation: RBI’s inflation projection for March – 11 is at 5.5% compared to FY March-10 estimate of 8.5% with an upward bias (the final figure was at 9.9%). RBI said inflation is no longer driven by supply side factors alone. First WPI non-food manufactured products (weight: 52.2 per cent) inflation, increased sharply from (-) 0.4%in November 2009, to 4.7% in March 2010. Fuel price inflation also surged from (-) 0.7 per cent in November 2009 to 12.7% in March 2010. Further, contribution of non-food items to overall WPI inflation, which was negative at (-) 0.4% in November 2009 rose sharply to 53.3% by March 2010. So, overall demand pressures on inflation are also beginning to show signs. These movements were visible in March 2010 itself, pushing RBI to increase rates before the official policy in April 2010. Monetary Aggregates: RBI has increased the projections of all three monetary aggregates for 2010-11. These projections have been made consistent with higher expected growth in 2010-11. Higher growth will lead to more demand for credit. Then management of government borrowing program will remain a challenge as well. High growth coupled with the borrowing program will need higher financial resources. Therefore, projections for money supply, credit and deposit are raised to 17%, 20% and 18% respectively. However, higher growth in money supply would also lead to build up of higher inflation and inflationary expectations. Growth in M3 is higher than M1 between April-November 2009. From Dec-2009 onwards, the growth rate in M1 is higher than M3. The difference in M1 and M3 comes from the growth rate in time and demand deposits. Growth in Time deposits is higher than demand deposits between AprilNovember 2009. From December 2009, onwards growth in demand deposits picks up. This in turn reflects in differences in growth rate of M1 and M3. The growth rate in currency is volatile. It declines 15% in August 2009 and then again increases to 17.9% in December 2009. It then declines to 15.6% in March 2010. Hence, the difference between M1 and M3 comes from surge in growth of demand deposits and decline in growth of time deposits. This could be interpreted in two ways. First, spending on consumption and production is increasing as economy has recovered from recession. Second, it could be people are spending now as they expect higher inflation in future. Higher inflation in future could also lead to higher returns on assets and property in future; therefore people prefer to spend now. It will be interesting to watch trends in M1 and M3 from now on as well. RBI also outlined downside risks with its projections:
  3. 3. First, there is still substantial uncertainty about the pace and shape of global recovery Second, if the global recovery does gain momentum, commodity and energy prices, which have been on the rise during the last one year, may harden further. This could put upwards pressure on inflation Third, monsoon will continue to play a vital role both from domestic demand and inflation perspective. Fourth, policies in advanced economies are likely to remain highly expansionary. High liquidity in global markets coupled with higher growth in emerging economies foreign capital flows are expected to remain higher. This will put pressure on exchange rate policy. RBI usually does not comment on its exchange rate policy. As the economic situation is exceptional, RBI also commented on India’s exchange rate policy. Policy Stance The policy stance remains unchanged from January 2010 policy. Table 3: Comparing RBI’s Policy Stance October 2009 Policy January 2010 Policy April 2010 Policy Watch inflation trend and be Anchor inflation expectations, prepared to respond swiftly while being prepared to respond appropriately, swiftly and effectively Monitor liquidity to meet and effectively to further of inflationary credit demands of productive build-up sectors while securing price pressures. Anchor inflation expectations, while being prepared to respond appropriately, swiftly and effectively to further build-up of inflationary pressures. Actively manage liquidity to ensure that the growth in demand for credit by both the private and public sectors is satisfied in a non-disruptive way. Actively manage liquidity to ensure that the growth in demand for credit by both the private and public sectors is satisfied in a non-disruptive way. and financial stability Maintain monetary and interest rate regime consistent with price and financial stability, and supportive of the growth process Maintain an interest rate Maintain an interest rate regime consistent with price, regime consistent with price, output and financial stability. output and financial stability. Summary: Given the economic outlook, policy ahead is going to remain challenging. There are many trade-offs RBI has to manage. It needs to manage high inflation without impacting the growth process. The recent inflation numbers show rising demand side pressures on inflation. The market participants are already looking at an increase of around 100-150 bps by March 2011 end. The higher interest rates would make it difficult to manage the government borrowing program and also invite more capital flows. High interest rates could also lead to higher lending costs for the corporate sector. The challenges are not limited to domestic factors alone. The concerns remain on future outlook of advanced economies which complicates the policy process further. DEVELOPMENTS IN THE MONETARY POLICY ARENA: The outflow of foreign exchange, as a fall out of the crisis, also meant tightening of liquidity situation in the economy. To deal with the liquidity crunch and the virtual freezing of international credit, the monetary stance underwent an abrupt change in the second half of 2008/09. The RBI responded to
  4. 4. the emergent situation by facilitating monetary expansion through decreases in the CRR, RR and RRR rates, and the statutory liquidity ratio (SLR). The RR was reduced by 400 basis points in five tranches from 9.0 in August 2008 to 5.0 percent beginning March 5, 2009. The R-RR was lowered by 250 basis points in three tranches from 6.0 (as was prevalent in November 2008) to 3.5 percent from March 5, 2009. The R-RR and RRs were again reduced by 25 basis points each with effect from April, 2009. SLR was lowered by 100 basis points from 25 percent of net demand and time liabilities (NDTL) to 24 percent with effect from the fortnight beginning November 2008. The CRR was lowered by 400 basis points in four tranches from 9.0 to 5.0 percent with effect from January 2009. 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 Repo rate Reverse repo rate Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Mar-10 Jul-10 Nov-10 Cash-reserve ratio It decided to retain the repo rate at 6.25 per cent and the reverse repo rate at 5.25 per cent under its Liquidity Adjustment Facility (LAF). It also retained the Cash Reserve Ratio (CRR) at 6 per cent of net demand and time liabilities (NDTL) of scheduled banks as per 2010 annual report. Economic Recovery: From all accounts, except for the agricultural sector as noted above, economic recovery seems to be well underway. Economic growth stood at 7 percent during the first half of the current fiscal year and the advance estimates for GDP growth for 2009-10 is 7.2 percent. The recovery in GDP growth for 2009-10, as indicated in the advance estimates, is broad based. Seven out of eight sectors/subsectors show a growth rate of 6.5 percent or higher. The exception, as of April 2010 9 anticipated, is agriculture and allied sectors where the growth rate is estimated to be minus 0.2 percent over 2008 09. Sectors including mining and quarrying; manufacturing; and electricity, gas and water supply have significantly improved their growth rates at over 8 percent in comparison with 2008-09. When compared to countries across the world, India stands out as one of the best performing economies. Although there is a clear moderation in growth from 9 percent levels to 7+ percent, the pace still makes India the fastest growing major economy after the People’s Republic of China. In order for India’s growth to be much more inclusive than what it has been, much higher level of public spending is needed in sectors, such as health and education along with the implementation of sectarian reforms so as to ensure timely and efficient service delivery. Plan allocations for 2010-11 for the social sectors have been stepped up, as can be seen from the figures below, this process however needs to be strengthened and sustained over time. Inclusive Development: • The spending on social sector has been increased to Rs.137,674 crore (US$ 30 billion) in 2010-11, which is 37 percent of the total plan outlay in 2010-11.
  5. 5. • Another 25 percent of the plan allocations are devoted to the development of rural infrastructure. Education • Plan allocation for school education increased by 16 percent from Rs.26,800 (US$ 6 billion) in 2009-10 to Rs.31,036 crore (US$ 7 billion) in 2010-11. • In addition, States will have access to Rs.3,675 crore (US$ 792 million) for elementary education under the Thirteenth Finance Commission grants for 2010-11. Health • Plan allocation to Ministry of Health & Family Welfare increased from Rs 19,534 crore (US$ 4 billion) in 2009-10 to Rs 22,300 crore (US$ 5 billion) for 2010-11. As expected, the measures undertaken by government of India to counter the effects of the global meltdown on the Indian economy have resulted in shortfall in revenues and substantial increases in government expenditures, leading to deviation from the fiscal consolidation path mandated under the Fiscal Responsibility and Budget Management (FRBM) Act. INDUSTRY IN LINE WITH RBI MONETARY POLICY CHANGES Industry today widely welcomed the changes introduced in the credit policy review, commending it for pausing on rate hikes and injecting liquidity into the banking system by lowering the Statutory Liquidity Ratio (SLR) by one percentage point. It said this will help short-term rates to cool down and help maintain stability in the macroeconomic environment. The Reserve Bank of India (RBI) in its policy review earlier in the day kept key interest rates on hold, but said inflation was significantly above its comfort level. However, the RBI brought down the SLR, or the minimum mandated amount of bonds that banks need to keep as a percentage of deposits, to 24 per cent from 25 per cent. It decided to retain the repo rate at 6.25 per cent and the reverse repo rate at 5.25 per cent under its Liquidity Adjustment Facility (LAF). It also retained the Cash Reserve Ratio (CRR) at 6 per cent of net demand and time liabilities (NDTL) of scheduled banks.