By Vaibhav Agrawal, Amit Rane (Angel Broking)

Policy marks shift in RBI's role to that of managing liquidity, rather than injecting liquidity

The RBI maintained a status quo with respect to all policy rates in its 2QFY2010 monetary policy. More important, in our view, was the marked change in the tone of the policy. The policy did sound more hawkish, emphasising concerns about inflation and describing the measures implemented as the first phase of an 'exit' from the extraordinary monetary accomodation of the past year. But this needs to be viewed in the context of the evolving dynamics of growth, inflation and liquidity.

Inflation focus more about managing expectations

While there are signs of an incipient revival in growth, with industrial growth picking up first, the RBI has noted that this recovery is fragile and any sharp monetary tightening at this stage could derail the same. Inflation is expected to increase going forward, but the RBI appears more concerned about inflation expectations than actual WPI inflation, which is going up partly on account of a base effect and partly on account of Food inflation, where the RBI acknowledges that monetary policy has little role to play. Moreover, apart from Asset prices going up, there are limited extant signs of demand-side pressures, given the low credit growth of 11% yoy, and the under-utilisation of capacity in several goods and services. The measures implemented in this policy relating to the withdrawal of special facilities are also unlikely to have any real impact on money supply or interest rates. The tone of the policy, providing reassurance on the RBI's commitment to price stability, should be seen in light of the need to address conventional concerns regarding a future build-up of demand-side pressures and anchoring of inflation expectations.

Capital inflow-driven liquidity appears the more substantive concern

In our view, looking beyond WPI and CPI inflation, the change in the RBI's tone appears to reflect an anticipated increase in capital inflows and the resultant issues of excess liquidity, asset price inflation and rupee appreciation (as we had described in our Preview, titled 'Dejà vu?'). Over the past year, the RBI has played a critical role in reviving domestic demand and ensuring financial stability by infusing huge amounts of liquidity to bring down interest rates in the economy. However, going forward, it is appearing likely that the RBI may increasingly have to play the role of managing liquidity, rather than injecting liquidity.

Managing forex-driven liquidity does not equal true monetary tightening, at this juncture

With ample liquidity in the system at present and expectations of accelerating capital inflows going forward, the RBI could possibly have to re-assume the role of sterilising excess liquidity in the system. But this needs to be distinguished from an intent to tighten liquidity and to clamp on broad money expansion, so as to curb demand. In fact, it is quite the opposite - the RBI continues to acknowledge the need to support growth at present (credit growth remains as low as 11% yoy, and it would be unwarranted to stifle the incipient revival in demand). If anything, the RBI has revised its Credit growth target down from 20% to 18%, and M3 growth target from 18% to 17%.

Our take is that, going forward, comfortable liquidity is likely to be ensured through forex inflows, and the RBI's role of infusing liquidity through its various tools is no longer required; rather, the RBI may have to resort to CRR hikes and MSS bonds again in the coming policies to sterilise any excesses - Déjà vu, indeed. In our view, the RBI will continue to maintain a stable rate of expansion in Reserve money (increasingly backed by Forex reserves, going forward, as opposed to CRR and MSS releases, and OMOs over the past year) so that expansion in Credit and M3 continues at a steady pace.

As seen in the past cycle, sterilisation was aimed at removing excessive liquidity from the system, with CRR hikes and MSS issuances matched on a more or less linear basis with the incoming forex flows. The RBI increased the supply of currency in the economy to the extent of about Rs80,000cr in both FY2007 and FY2008, backing it with foreign currency inflows. However, inflows were far in excess of this requirement and the RBI had to sterilize about 70% of the same in each of the two years, with domestic banks sharing 60% of the burden through CRR and the Government bearing 40% through MSS, LAF, etc.

Elasticity of credit demand low when economic activity buoyed by capital inflows high

We had said this in our Monetary Policy Preview and it bears reiteration: It should be kept in mind that withdrawal of the monetary accomodation 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 2008, the credit growth rate remained above 20% yoy - and, eventually, it was the global crisis that truly dampened demand. The strength of credit demand inspite of a 300-400bp increase in interest rates, caused by monetary tightening, suggested a low elasticity of credit demand in an environment of robust economic activity and opportunity, buoyed by cheap foreign capital (especially risk capital) and strong domestic savings. The situation, as it stands today, appears to be headed in a similar direction.

Policy marks divergence of RBI's monetary stance from that of the US Federal Reserve

The above interpretation of the monetary policy stance is predicated on the assumption of healthy capital inflows, going forward, in the absence of which, coupled with domestic monetary tightening, it is not evident if demand-side pressures on prices would become a deeper concern in the first place. In fact, the Policy's concerned tone could suggest a contemplated acceleration in capital inflows.

There is reason to be optimistic about capital inflows. Major central banks remain extremely accomodative, with the US Federal Reserve (Fed) expressing its intention to maintain such a stance for an extended period of time, in the backdrop of almost 10% unemployment in the US. In the aftermath of the crisis, the Fed had resorted to an unprecedented increase in the US Monetary Base (broadly corresponds to India's Reserve Money), doubling it to US $1.6tn by December 2008, which amounted to 12% of US GDP, after remaining at 6% of GDP for five decades. This proved to be extremely successful in reducing the risk aversion in the global financial system, gradually leading to financial stability.

Since then, M1 growth has been in the range of 13-19% yoy, after about 24 months of de-growth, indicating that the liquidity is increasingly entering the real economy. Moreover, M2 growth in the US (broadly corresponds to India's M3) has also ranged between a healthy 7-10% yoy. On top of this, even in its latest Monetary Policy, the Fed has indicated plans to almost double the Monetary Base from these, already-elevated levels. All this suggests that, going forward, if anything, global liquidity is only going to increase and flow in the real economy to a greater extent, as GDP, savings, investments and credit growth pick up. At this juncture, it is not clear how far the RBI would be concerned about asset-inflation - this is a controversial issue for Central Banks. But in this context, so long as the Federal Reserve and other major Central Banks remain extremely accomodative, it may be challenging for domestic monetary policy in India to implement conservative policies on a unilateral basis in the near-term.

Changes relating to the Banking Sector

SLR hiked to 25%
The SLR hike from 24% to 25% will have no material impact, as banks are already holding excess SLR (27.6% of NDTL net of LAF collateral, 30.4% on a gross basis).

NPA Provision coverage to be minimum 70%
The increase in the minimum provision coverage to 70% does not impact our valuations, since these are based on Book-Value adjusted for Provision Coverage below 75%, wherever applicable. Banks could request the RBI to make initial adjustments through the Balance Sheet, rather than the P/L; otherwise, this could be a sentiment negative. Over the course of a credit cycle, in any case, it is eventually actual losses on irrecoverable NPAs that get accounted through the P/L, keeping in mind both provisioning and recoveries.

Prudential measures

The RBI had provided a host of counter-cyclical relaxations in light of the crisis, such as reduction in risk weightages and Standard Provisioning requirements on loans to Sensitive sectors, and putting certain Basel 2 measures in abeyance. These are inevitably going to be reversed. In this policy, on a positive note, the RBI has taken prudential measures to begin the process of increasing the systemic strength of the domestic Banking sector. Standard Provisioning requirements on  Commercial Real Estate loans (which were 2% pre-crisis) have been increased from 0.4% at present to 1%, in light of the strong 42% yoy growth in loans to the sector and the large quantum of restructuring in the same. While the elasticity of credit demand in a booming market should not be over-estimated, looking at the past experience, these steps are in the right direction and essential to addressing potential asset-price inflation. The P/L impact is expected to be small, though relatively higher for banks such as PNB, which had increased their exposure to the sector, especially in the past one year.

Among other measures/proposals, norms on the Duration Gap based ALM could be interesting, depending on the disclosure levels mandated. Alignment of Infrastructure NBFC Risk weightages in line with Credit Rating should generally lead to a release of Capital for most, and should lead to lower interest rates and greater availability of credit to them. Liabilities of banks from transactions in the collateralised borrowing and lending market (CBLO) will now be subject to cash reserve requirements, which will have a minimal impact.

Banking Sector Outlook

Broadly, in our view, the RBI's commitment to maintain comfortable liquidity (as distinguished from excess liquidity, but by no means tight liquidity) should allow interest rates to remain low over the coming quarters, adding greater momentum to the imminent upturn in GDP growth. We believe that low interest rates, combined with the reducing leverage in borrowers' balance sheets, due to equity-raising and rising earnings, will help revive credit demand from 2HFY2010E onwards. Potential Monetary tightening measures, such as CRR hikes in the coming policies, are unlikely to dampen demand anytime soon; rather, such measures are likely only if Capital inflows are robust in the first place, which will actually improve the GDP growth, Savings and Investments, and the Banking sector growth outlook. Within the sector, we prefer private banks, in light of their stronger core competitiveness and likelihood of market share gains, as the external environment becomes more conducive from 2HFY2010E onwards. Axis Bank remains our top pick in the sector.