News & Analysis » India

Indian monetary policy preview (1QFY2010)

Angel Broking presents Indian 1QFY2010 monetary policy preview:

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, bring down interest rates and unfreeze financial markets. Due to structural advantages like favorable demographics, low leverage and wide gap in productivity levels creating scope for rapid catch-up, emerging markets have naturally been the first to respond positively to this growth stimulus, though we are still a long distance from pre-crisis growth trajectories.

In 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 and are therefore not aiming for less. We still need public spending to prop up economic activity over the next 6-12 months so that a 7-8% growth rate can be maintained – to its credit, the budget fulfils this need, by stepping up expenditure by Rs1.2lakh cr over last year. Throughout the crisis, the RBI has also been very proactive in providing liquidity to the system, releasing about Rs2.5lakh cr in the form of CRR cuts and MSS redemptions and also cutting the Repo and Reverse Repo rates rapidly to 4.75% and 3.25% from peaks of 9% and 6% respectively. As a result, broader lending and deposit rates have also gradually come down by 200-300bp on an average.

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 crowding out of the private sector. However, in our view, the government is receptive both to the need for stimulating economic activity through fiscal spending and the possibility of keeping interest rates low over the next six to nine months through monetisation for supporting a revival in private sector demand i.e. the two things are not mutually exclusive at the present juncture. In our view, the RBI’s commitment to support the government borrowing programme through open market operations, which effectively amounts to monetisation, should keep interest rates low over the next few quarters, adding greater momentum to the imminent upturn in our GDP growth.

In our opinion the RBI is likely to maintain status quo in respect of policy rates in the upcoming policy. The important thing to watch out for is whether the RBI will provide further clarity on the expected size of open market operations for the whole of FY2010E i.e. confirming or denying the government’s indications that the operations will be stepped up from Rs80,000cr at present to Rs2 lakh cr. Overall, we expect the RBI to maintain an unequivocally accommodative stance as the key priority for the economy is to keep interest rates low over the next six to nine months to support a revival in domestic demand.

Open Market Operations a big positive; interest rates to remain low for another six to nine months

Post the budget, the Government indicated that indirect financing of the Fiscal deficit by the RBI could be stepped up to Rs2lakh cr from the present Rs80,000cr. With this kind of support, it is unlikely that interest rates will inch up over the next few quarters. Moreover, banks in any case are already 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 22% growth in deposits even though credit growth has slowed to 15-16%.

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. The RBI increased the supply of currency in the economy to the extent of about Rs80,000cr in both FY2007 and FY2008, although it has had more than adequate foreign currency inflows to back the same instead of government debt. In FY2009, the increase in the currency component of Reserve money was as high asRs1 lakh cr, about 65% of which was met by the liquidity released due to CRR cuts. In FY2010E, so long as forex inflows remain subdued going forward, the RBI in any case must increase the amount of reserve money in the system to support the higher GDP and this will have to be done against government debt.

Secondly, with growth in broader money supply (termed as M3, which includes public and private credit and foreign exchange) being subdued on account of slowing credit growth and low forex inflows, a higher magnitude of quantitative easing by the RBI is also recommended over and above the normal incremental requirements of currency. This is 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 growth in money supply picks up faster than expected, the RBI has several tools, including MSS bonds and CRR, to absorb liquidity quickly – but, 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 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. Infact, keeping interest rates low should be the RBI’s key priority so that Indian companies can access funds cheaply to build supply capacities and increase employment so that the huge latent demand in our country can be unlocked.

The external environment is also conducive for monetisation – inflation is at a multi-decade low and low interest rates are a global priority. The US Federal Reserve’s massive US$ 3 trillion Bailout plans address the need to bring down interest rates across the world. This enormous printing of money has set a precedent for Central Banks across the world and we believe there is every reason for the Indian Government to monetize a part of its fiscal stimulus in order to bring our GDP growth back to a high growth trajectory.

Accordingly, we expect the RBI to continue its support to the Government’s borrowing programme through Open Market Operations, though we await clarity from the monetary policy as to the quantum of these operations planned for FY2010E. We maintain our view that combined with the country’s strong domestic savings, such steps will help keep interest rates low over the next six to nine months, adding greater momentum to the imminent upturn in our GDP growth.