News & Analysis » India

Indian 2QFY2010 Monetary Policy Preview

Contributed by Angel Broking

By Vaibhav Agrawal, Amit Rane (Angel Broking)

In our opinion, the RBI is likely to maintain status quo with respect to policy rates in the upcoming policy, reiterating that its priority remains growth rather than inflation at this juncture. An important thing to watch out for will be RBI's take on the potential acceleration of forex inflows going forward, and the resultant problems of high liquidity, the appreciating rupee as well as rising asset prices and demand-side pressures that the country may have to face all over again. Such inflows may necessitate CRR hikes in subsequent policies though, over the next 4-6 quarters at least, such hikes will, in our view, only manage to sterilize the excess forex-driven liquidity in the system, rather than stifling growth by choking off M3. Overall, for the upcoming policy, we expect the RBI to maintain an accommodative stance, as the key priority for the economy remains keeping interest rates low until a broad-based revival in domestic demand is firmly rooted.

Policy-makers committed to growth

Ever since September 2008, when the global crisis intensified, Central banks across the world have resorted to unprecedented fiscal stimulus and monetary easing to revive economic activity, to bring down interest rates and to unfreeze financial markets. Due to structural advantages, emerging markets have been the first to respond positively to this growth stimulus, though we are still a long distance from pre-crisis growth trajectories. In the case of India, the good news is that policy-makers recognize that sufficient policy tools are available to take the economy back to 8%+ GDP growth rates; therefore, they are not aiming for less. The large Fiscal deficit is definitely the need of the hour to prop up economic activity over the next 6-12 months. Throughout the crisis, the RBI has also been very proactive in providing liquidity to the system, due to which broader lending and deposit rates have also gradually come down by 300-350bp on an average.

For a broad-based revival in growth to take root, we believe interest rates need to remain low for at least a few more quarters. Based on our analysis of the demand and supply of funds in the economy, as things stand, lending and deposit rates are in fact unlikely to go up for such a period. It is unlikely that the RBI would like to hike any of the policy rates to alter this probable trajectory for interest rates at this juncture.

System to remain flush with liquidity

With all the government spending, the combined fiscal deficit is expected to be as high as 11% of GDP in FY2010E, sparking concerns about rising interest rates and the crowding-out of the private sector. However, Banks remain flush with liquidity, having deployed an excess of almost Rs 4 lakh crore in risk-free investments like government bonds and reverse repo auctions, as strong domestic savings continue to drive a 20% growth in deposits, even though credit growth has slowed to 10-11%.

RBI not too worried about inflation

The high fiscal deficit and its potential monetisation have raised concerns about the return of inflation in the next few quarters, which are unjustified at this juncture, in our view. First of all, the RBI's Open Market Operations are not in excess of what the economy can absorb. Secondly, with growth in broader money supply being subdued on account of slowing credit growth and low forex inflows, a higher magnitude of quantitative easing by the RBI is in any case appropriate to keep interest rates low and spur demand for credit, otherwise the revival in economic growth could be stifled at an incipient stage. Thirdly, even if the growth in money supply picks up faster than expected, the RBI has several tools, including MSS bonds and CRR, to absorb liquidity quickly; yet, we are far away from that scenario at present.

There are concerns that the Consumer Price Inflation, which is already prevailing at elevated double-digit levels, could go up further on account of the rising food and fuel prices. In this regard, it is pertinent to note that the RBI itself does not view pure inflation targeting as very feasible in the Indian context. In India, inflation has largely been a function of supply constraints and global commodity prices, rather than easy-money driven excess demand. The RBI has also noted that the changing inflation environment is being driven by a strong escalation in the prices of food articles, which have increased by 14.4% this fiscal. Excluding food items, the WPI inflation remains negative, at -3.4%. Looking at global inflationary pressures, the Reuters/Jefferies Commodities Price Index, which captures a wide basket of global commodity prices, is at its lowest level since September 2004 and is still showing a declining trend.

Eventual tightening to be a gradual process, one that is unlikely to affect demand anytime soon

By early FY2011E, the RBI may have to start considering a measured withdrawal of monetary accommodation, provided the growth impulses in the economy are unmistakable by then. Moreover, withdrawal of liquidity may also be precipitated by any potential surge in foreign capital inflows. Already, Equity inflows have been very strong so far this year. FDI inflows were as high as US$6.8bn in 1QFY2010, after averaging about US$2.5bn in the preceding three quarters. FII inflows have been even more robust at US$16bn YTD in FY2010. An important thing to watch out for in thispolicy will, therefore, be the RBI's take on the potential acceleration of forex inflows going forward, and the resultant problems of high liquidity, the appreciating rupee as well as rising asset prices and demand-side pressures that the country may have to face all over again. Such inflows may necessitate CRR hikes in subsequent policies. However, the important thing to note in this regard is that, over the next 4-6 quarters at least, such hikes will, in our view, only be aimed at sterilizing the excess forex-driven liquidity in the system, rather than stifling growth by choking off M3.

It should be kept in mind that the withdrawal of the monetary accommodation will in any case be gradual, likely over a period of a couple of years under normal circumstances, and unlikely to stifle demand until that process reaches an advanced state. For instance, even in the previous rate-tightening cycle, progressive rate hikes and CRR hikes from October 2004 were unable to curtail credit demand - in fact, up to December 2006, the credit growth rate remained above 30% yoy - and it was the global crisis that truly dampened the demand, eventually.