RBI Annual Policy Review May03,2011

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RBI Annual Policy Review 2011-12

May 03, 2011


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Reserve Bank of India (RBI) announced its annual monetary policy for 2011-12 today May 03, 2011. RBI maintained inflationmanagement as its top priority. Key features of the monetary policy statement are:

Repo rate increase by 50 bps to 7.25% with immediate effect and will be the only independent policy rate to signal

monetary policy stance

Reverse repo rate raised by 50 bps to 6.25% as it has been pegged 100 bps below repo rate

CRR and SLR were left unchanged

Marginal Standing Facility (MSF) instituted 100 bps above repo rate. Banks can borrow up to one percent of their net

demand and time liabilities (NDTL) from May 07, 2011.

Savings rate increased by 50 bps to 4%.

RBI increased policy rates by 50 bps and clearly outlined that inflation management will be its top priority even if it comes at acost of growth in the short run. RBI held that price stability in the economy is essential to sustain growth over the medium term

and hence reining inflation takes precedence, even if it comes at a cost of growth. Having admitted the risk of upsides to infla-

tion and its priority to rein in inflation at the costs of growth RBI has clearly laid the path of rising interest rates scenario.

Repo and reverse repo increased by 50bps

Impact: Increase in the policy rates will increase the borrowing and lending costs for banks, this in turn will lead to overall

increase in the interest rates for the economy. Elevated levels of inflation will lead to a high interest rates environment which

would impact growth. As RBI has clearly stated price stability as its top priority, we believe that more interest rates hikes are

due in the course. As domestic fuel prices are yet to fully adjust to the current crude oil levels, we expect inflation to continue

to remain high for some more time. The increase in the repo rates has been higher from our expectations of 25 bps hike.

Changes in the operating procedure of monetary policy.

Impact:Now repo rate will be the only independent policy rate to signal monetary policy stance. As repo rate has beenmade

the only independent policy rate with immediate effect it will help to accurately signal the monetary policy stance. Reverse

repo rate will be automatically derived from repo rate as it has been pegged 100 bps lower from repo rate. MSF rate will be 100

bps over the repo rate, thus the revised corridor will have fixed width of 200 bps with repo rate in the middle. This system will

remove ambiguity in the monetary system as the interest rates and their procedures have been clearly defined.

CRR and SLR unchanged:

Impact: RBI left CRR and SLR unchanged at 6% and 24% respectively. CRR and SLR were left unchangedwhich is consis-

tent with RBIs policystance as money supply has been lower from its projections. Also as liquidity has been comfortable in

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CRR (%) Repo (%) Reverse Repo (%)

Monetary Policy Rate Movement


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the system post decline in Governments cash balances therefore doesnt require any warrants any reduction.

Savings rate hiked by 50 bps

Impact: RBI increased savings rates by 50 bps to 4%. This will help albeit marginally to reduce the spread between

term deposits and savings deposits for savers. As the decision on savings rate deregulation is pending and has been put

for discussion until then rise in savings rate is quite minimal and will not impact banks profitability.

RBIs domestic outlook for 2011-12

Growth: RBI has projected 8% YoY GDP growth for FY12 on the assumption of normal monsoons and average crude

oil projection of USD110 per barrel in FY12. RBI expects growth to moderate due to higher oil and commodity prices

and its anti inflationary stance which will impact growth. RBI expects growth in the band of 7.4% to 8.5% for FY12

with 90% probability.

RBIs survey for June 2011 quarter points to moderation in business confidence. Higher interest rates environment with

slower investment and lower industrial activity is expected to lower GDP growth compared with FY11.

Inflation: RBIs inflation projection for March 2012 is 6% YoY with an upward bias compared with March 2010 esti-

mate of 8% YoY while the actual stood at 9% YoY. RBI has placed inflation forecast based on current domestic de-

mand supply situation and global trends in the commodity prices. RBI expects Inflation to remain at an elevated level in

the first half of the FY12 due to expected pass-through of increase in international petroleum product prices to domesticprices and continued pass-through of high input prices into manufactured products.

RBI is strongly of the view that controlling inflation is essential for sustaining growth over the medium-term as infla-

tion impacts investment climate, on which growth sustainability depends and also to lower uncertainty from the system.

Monetary aggregates: RBI projected Money supply (M3) growth of 16% in FY12 in order to balance the resource re-

quirements of the credit demand and the budgeted government borrowings. For FY12, deposits growth is projected at

17% and non food credit growth of SCBs at 19%. Credit growth for FY12 has been projected lower compared with

21% growth in FY11.

M3, credit and deposit growth has been projected lower for FY12 by RBI due to lower economic growth and high infla-

tion outlook for the year. As RBI expects growth to moderate from FY11 levels and decline in business confidence will

impact these monetary aggregates. The monetary projections provided by RBI are indicative estimates and not targets.

Risks: RBI also outlined downside risks to its growth and inflation projections. Indicative growth and inflation projec-

tions have several risks factors.

RBIs Indicative Projections (All Fig In %, YoY)

March 2011policy

FY11 Actual/expected

FY12 estimates/projections

GDP 8.6 8.6 8

Inflation (based on WPI, for Marchend)

8 9.0 6

Money Supply (March end) 17 15.9 16

Credit (March end) 20 21.2 19

Deposit (March end) 18 18.4 17

Source: RBI


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1. Significant slower global recovery can impact the Indian economy through the trade, finance and confidence chan-nels. Risks to global growth are at this stage from sovereign debt problems in Euro zone, high commodity prices,

abrupt rise in long term rates in advanced economies, further rise in inflation pressures in emerging economies

(EMEs).

2. Global commodity prices are a significant risk factor for both domestic growth and inflation. The future path of crude

oil prices is uncertain and therefore risk remains.

3. Subsidy burden poses a risk as higher fuel prices have not been passed on.

4. Food inflation remains a challenge as supply is not able to keep pace with the growing demand. Given the spike in

international food prices even in significantly traded food items, imports do not provide an option to cushion domes-

tic prices. Persistently high food prices are likely to exert sustained upward pressure on wages, thus transmitting

through to wider cost pressure on prices.

5. Higher oil and commodity prices can impact CAD. Financing of CAD is going to be a challenge as advanced coun-tries begin exiting from their accommodative monetary policy stance. This could slow down capital inflows to EMEs,

including India.

Policy stance

Policy stance has seen a sharp change from March 2011 quarterly policy review as today in its annual policy review RBI

has clearly outlined inflation management as its priority even at the cost of growth.

Summary:

RBI has clearly outlined its priority to manage inflation until it visibly moderates. RBI expects that its monetary stance of hiking

interest rates will cool off demand pressures and therefore will check inflationary expectations from the demand side as growthmoderates. RBI expects that the impact of monetary hikes that it has taken will start showing result in the second half ofFY12. Until inflationary expectations subside RBI will continue to prioritise inflation management. The central idea for

RBIs annual policy can be gauged from its statement; Over the long run, high inflation is inimical to sustained growthas it harms investment by creating uncertainty. Current elevated rates of inflation pose significant risks to future growth.Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence.

RBIs Policy Stance ComparisonApril 2010 Policy March 2011 Policy May 2011 Policy

Anchor inflation expectations,while preparing to respond ap-

propriately, swiftly and effec-tively to stem build-up of infla-

tionary pressures

Actively manage liquidity to en-

sure growth in demand for credit

-- private and public -- is satis-fied non-disruptively

Maintain an interest rate regimeconsistent with price, output and

financial stability

Contain the spill-over of high food

and fuel inflation into generalizedinflation and anchor inflationary

expectations, while being prepared

to respond to any further build-up

of inflationarypressures.

Maintain an interest rate regime

consistent with price, output and

financial stability.

Manage liquidity to ensure that it

remains broadly in balance, withneither a surplus diluting monetary

transmission nor a deficit chokingoff fund flows.

Maintain an interest rate environ-

ment that moderates inflation andanchors inflation expectations.

Foster an environment of price sta-

bility that is conducive to sustain-

ing growth in the medium-term

coupled with financial stability.

Manage liquidity to ensure that it

remains broadly in balance, with

neither a large surplus dilutingmonetary transmission nor a large

deficit choking off fund flows.

Source: RBI


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RBIs policy stance will result in moderation of economic growth in FY12. As outlook for crude oil remains high its

impact will be seen on economic growth not only in India but across the globe. We think that RBI has chosen inflation

management over growth to check deteriorating investment climate which will impact economic growth in the long run.

Recent data on FDI also points out to moderation in investment climate. We expect further hikes in interest rates going

forward in line with RBIs monetary policy stance. As inflation is commodity led and due to uncertainty in Middle East

and North Africa, efficacy of hiking interest rates to check import led inflation is therefore limited and we believe that

growths versus inflation debate will soon re emerge.

Development and Regulatory PoliciesIn its annual and mid-term review of monetary policy, RBI also covers developments and proposed policy changes in

the financial system. Some of those announced in this review are:

Setting up new banks

To provide banking access to all villages with population of over 2000 by March 2012 RBI has identified 72,800

villages. RBI will ask banks to ensure that at least 25 per cent of the new branches being opened during this year

are located in tier 5 and tier 6 centres.

Financial markets

The Reserve Bank will shortly issue the final guidelines on credit default swaps. The product will be launched

once the necessary market infrastructure is in place.

The period of short sale in government securities will be extended from the existing five days to a maximum of

three months.

FIIs will be allowed to cancel and rebook up to 10 per cent of the market value of the portfolio as at the beginning

of the financial year.

Regulatory

Investment by banks in liquid schemes of debt oriented mutual funds will be subject to a prudential cap of 10 % of

their net worth as on March 31 of the previous year. However, with a view to ensuring a smooth transition, banks

which are already having investments in DoMFs in excess of the 10 % t limit, will be allowed to comply with this

requirement in six months time.

Advances classified as sub-standard will attract a provision of 15 per cent as against the existing 10 per cent (the

unsecured exposures classified as sub-standard assets will attract an additional provision of 10 per cent, i.e., a totalof 25 per cent as against the existing 20 per cent).

The secured portion of advances which have remained in doubtful category up to one year will attract a provision

of 25 % (as against the existing 20%).

Credit delivery

The Reserve Bank is closely monitoring the achievement of targets by banks on a half-yearly basis, i.e., March and

September each year. A suitable format has been devised by the Reserve Bank to capture and monitor the achieve-

ment of the targets by banks and the same are regularly reviewed at the highest level. Banks, which lag behind in

achieving the targets, have been mandated to submit an action plan to achieve the prescribed targets.

Bank loans to all MFIs, including NBFCs working as MFIs on or after April 1, 2011, will be eligible for classifica-tion as priority sector loans if, they conform to the regulations formulated by RBI. As per Malegam Committee, the

RBI has also decided to appoint a Committee to review the priority sector lending classification.


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RBI Annual Policy Review May03,2011

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