Monetrix

The Finance and Economics Club MDI Gurgaon

Presents

Reserve Bank of India Economics

(Monthly Knowledge Series @ FinStreet: July 2012)

Monthly Knowledge Series @ FinStreet: July 2012

Monetrix, MDI Gurgaon

The Reserve Bank of India - Economics

A few terms & concepts to begin with: i) Headline Inflation: Raw inflation figure calculated through CPI. It finds the cost to purchase a fixed basket of goods and services. It is done year on year basis by keeping a base year and indexing prices based on it. ii) Core Inflation: It is the headline figure adjusted for food and energy prices. It is an important metric as it negates the fluctuations based on crude prices, currency, food related supply side effects and inconsistent monsoons. iii) Wholesale Price Index: An index that measures and tracks the changes in price of goods in the stages before the retail level. Wholesale price indexes (WPIs) report monthly to show the average price changes of goods sold in bulk, and they are a group of the indicators that follow growth in the economy. iv) Consumer Price Index: A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. v) Gross Domestic Product: The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory. GDP = C + G + I + NX where: "C" is equal to all private consumption, or consumer spending, in a nation's economy "G" is the sum of government spending "I" is the sum of all the country's businesses spending on capital "NX" is the nation's total net exports, calculated as total exports minus total imports. (NX = Exports - Imports) vi) Repo Rate: It is the rate at which RBI lends to banks so that they can meet the gap between the demands they are facing as loans and how much they have on hand to lend. RBI uses this to inject liquidity in the system. Currently 8.0%. vii) Reverse Repo Rate: It is the rate at which banks lend to RBI. RBI uses this to suck liquidity by ascertaining the amount of money floating in the system. Currently 7.0%.
1

Monthly Knowledge Series @ FinStreet: July 2012

Monetrix, MDI Gurgaon

viii)

Cash Reserve Ratio: It is the percent of depositors balances banks have to keep with RBI. Currently 4.75%. Statutory Liquidity Ratio: It is the amount of depositors balances bank must keep as liquid assets in the form of gold, government securities and cash. Currently 23%. Bank Rate: It is the rate at which RBI lends to banks. It essentially signals RBIs long term outlook on interest. Currently 9%.

ix)

x)

xi)

Liquidity Adjustment Facility: It is a tool employed by RBI to aid banks in adjusting to short term needs. It is done using repurchase agreements.

xii)

Gross Fixed Capital Formation: It refers to the net increase in physical assets (investment minus disposals) within the measurement period. It does not account for the consumption (depreciation) of fixed capital, and also does not include land purchases.

xiii)

M1: A category of the money supply that includes all physical money such as coins and currency; it also includes demand deposits, which are checking accounts, and Negotiable Order of Withdrawal (NOW) Accounts.

xiv)

M2: A category within the money supply that includes M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds. Economists use M2 when looking to quantify the amount of money in circulation.

xv)

M3: The category of the money supply that includes M2 as well as all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets.

xvi)

Open Market Operations: The buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. Purchases inject money into the banking system and stimulate growth while sales of securities do the opposite.

xvii)

Marginal Standing Facility (MSF): The facility where banks can borrow from RBI using the securities under SLR as collateral. The MSF rate is 1% above the Repo rate. In case of borrowing from the marginal standing facility, banks can borrow funds up to 1% of their net demand and time liabilities.

Having understood the fundamentals, its time to take a look at whats happening in India and why RBIs behaving this way. As a caveat, we would request you to acknowledge the fact that this is the view of RBI only. And to most of us at Monetrix, it seems correct. At least RBIs more transparent, more accountable and better equipped than our beloved coalition government which seems to suck at all times. We shall try to understand RBI policies since Jan 2012 and why they did what they did.
2

Monthly Knowledge Series @ FinStreet: July 2012

Monetrix, MDI Gurgaon

1. Annual Policy Statement for the year 2012-2013 April 16th 2012

I.

Background:

i)

Global Developments: Concerns about a crisis in the euro area had abated by then. The US

economy continued to show signs of modest recovery. Large scale liquidity infusions by the European Central Bank had significantly reduced the stress in global financial markets. However, a sustainable solution to the euro area debt problem was yet to emerge. Debt problems, for example in Spain, indicated that the euro area sovereign issues would continue to weigh on the global economy. Growth had also slowed down in emerging and developing economies (EDEs) which reflected the combined impact of monetary tightening and slowdown in global growth. And, amidst all these, international crude oil prices rose by about 10 per cent since January and showed signs of persisting at current levels.

ii) Domestic Developments:

Growth: Economic growth had decelerated since last year, dropping from 7.7 per cent in the first quarter to 6.9 per cent in the second quarter and further down to 6.1 per cent in the third quarter. This was mainly due to deceleration in industrial growth. Growth in the services sector had held up relatively well. On the demand side, gross fixed capital formation had contracted both in the second and third quarters of last year.

Inflation: Headline WPI inflation, which had remained above 9 per cent during AprilNovember 2011, had moderated to 6.9 per cent by end-March 2012. Food articles inflation continued to be high. Significantly. Inflation in protein items was in double digits, reflecting persistent structural demand-supply imbalances in protein foods. Fuel inflation, on the other hand, had moderated from over 15 per cent in November-December 2011 to 10.4 per cent in March 2012 even as global crude oil prices rose sharply. This reflected the absence of a commensurate pass-through to domestic consumers. Non-food manufactured products inflation had decelerated significantly from 8.4 per cent in November 2011 to 4.7 per cent in March 2012, on the back of a slowdown in domestic demand and softening of global non-oil commodity prices. Even as WPI inflation had softened, inflation as measured by the new series of consumer price index (CPI) suggested that price pressures were still high at the retail level.

Monthly Knowledge Series @ FinStreet: July 2012

Monetrix, MDI Gurgaon

Monetary and liquidity conditions: Liquidity management had remained a major challenge for the Reserve Bank during last year. Beginning November 2011, the liquidity deficit went much beyond the comfort level of the Reserve Bank. In order to redress this, they took steps to inject primary liquidity of a more durable nature. They injected liquidity of around Rs. 1.3 trillion through open market operations and Rs. 0.8 trillion through reductions in the cash reserve ratio (CRR) by 125 basis points.

II.

Policy Move: They reduced the repo rate under the liquidity adjustment facility (LAF) by 50 basis points. The repo rate accordingly dropped from 8.5 to 8.0 per cent. Consequent to this, the reverse repo rate under the LAF, determined with a spread of 100 basis points below the repo rate, got calibrated to 7.0 per cent. Similarly, the marginal standing facility (MSF) rate, which has a spread of 100 bps above the repo rate, stood adjusted to 9.0 per cent. In order to provide greater liquidity cushion, they had also decided to raise the borrowing limit of scheduled commercial banks under the marginal standing facility (MSF) from one per cent to two per cent of their net demand and time liabilities (NDTL).

III.

Expected Outcome: Growth: expected to stabilize around its then current post-crisis trend Inflation: expected resurging would be curtailed Liquidity: cushion available to banks would be enhanced

Monthly Knowledge Series @ FinStreet: July 2012

Monetrix, MDI Gurgaon

2. Mid quarter review of Monetary Policy 2012-2013 June 18th 2012

I.

Background

i)

Global Developments: The euro area sovereign debt problem had continued to weigh on the global recovery. After a brief phase of relative calm reflecting the large liquidity injection by the European Central Bank (ECB), renewed concerns had arisen about a sustainable solution to the sovereign debt problem and the increasing vulnerability of the banking sector. The then recent data suggested that US economic recovery was weakening. Growth in major emerging and developing economies (EDEs) was also moderating. While slowing global growth had dampened commodity prices, heightened risk aversion and the resultant slowing of capital flows was expected to have a significant adverse impact on EDEs, including India. Also, should there be an event shock, central banks in advanced economies would likely do another round of quantitative easing. This would have an adverse impact on growth and inflation in EDEs, particularly on oil importing countries such as India, through a possible rebound in commodity prices.

ii) Domestic Developments: Growth: Economic activity in 2011-12 moderated sequentially over the quarters to take growth to a low of 5.3 per cent in Q4, though for the year as a whole it was 6.5 per cent. Deceleration in industrial production from the supply side and weak investment from the demand side had, in particular, contributed to the growth slowdown. The index of industrial production (IIP) increased by just 0.1 per cent in April 2012. Inflation: During 2011-12, headline WPI inflation rate moderated from a peak of 10.0 per cent in September 2011 to 7.7 per cent in March 2012. However, during 2012-13 hence far, provisional data suggested that it inched up from 7.2 per cent in April to 7.6 per cent in May, driven mainly by food and fuel prices. Though international crude prices had fallen significantly from their levels in April 2012, the rupee depreciation had significantly offset its impact on wholesale prices. Further, even at the current lower level of global crude oil prices, significant under-recoveries persisted in respect of administered petroleum product prices. The positive development on the inflation front was that core (non-food manufactured products) inflation had trended down. The persistence of overall inflation both at the wholesale and retail levels, in the face of significant growth slowdown, pointed to
5

Monthly Knowledge Series @ FinStreet: July 2012

Monetrix, MDI Gurgaon

serious supply bottlenecks and sticky inflation expectations. The subsidy burden on the Government was crowding out public investment at a time when reviving investment, both public and private, was a critical imperative. Monetary and Liquidity Conditions: Although money supply (M3) growth had been slightly under the projected trajectory, credit growth had moved above the projected rate. Notably, the widening wedge between deposit growth and credit growth was intensifying liquidity pressures (owing to the anti-inflationary stance of RBI). However, the open market operations (OMOs) had substantially eased liquidity conditions, as was reflected in the stabilization of the overnight call money rate close to the policy repo rate. To further augment liquidity and encourage banks to increase credit flow to the export sector, the Reserve Bank had increased the limit of export credit refinance from 15 per cent of outstanding export credit of banks to 50 per cent, which would have released additionally liquidity of over `300 billion, equivalent to about 50 basis points reduction in the CRR. External Sector: The widening CAD, in the face of worsening global economic and financial conditions, exerted downward pressure on the rupee. As capital inflows continued to remain muted, the rupee had further depreciated since April. Prospects for increasing capital inflows depended on both global conditions, particularly a credible resolution of the euro area situation, and an improvement in the domestic investment climate.

iii) Guidance It was said that the evolving growth-inflation dynamic would continue to influence the Reserve Bank's stance on interest rates. Core inflation had moderated, reflecting average demand conditions and lower pricing power. However, both headline and retail inflation rates were rising, which had a bearing on inflation expectations. It was also note that RBIs future actions would depend on a continuing assessment of external and domestic developments that contribute to lowering inflation risks.

Monthly Knowledge Series @ FinStreet: July 2012

Monetrix, MDI Gurgaon

3. First quarter review of Monetary Policy 2012-2013 July 31st 2012

I.

Background:

i)

Global Developments: Global macroeconomic conditions deteriorated since the previous monetary policy meeting. US economic recovery also slowed down as shown by the weak GDP growth figure of 1.5%.

ii)

Domestic Developments:

Growth: Deteriorating global macroeconomic conditions and weak monsoons led RBI to reduce GDP growth projections for India from 7.3% to 6.5%.

Inflation: Headline WPI inflation increased from 7.5 per cent in April to 7.6 per cent in May before moderating to 7.3 per cent in June 2012. The stickiness in inflation, despite the significant growth slowdown, was largely on account of high primary food inflation, which was in double-digits during the first quarter driven by a spike in vegetable prices and sustained high inflation in protein items. Fuel group inflation moderated from 12.1 per cent in April 2012 to 11.5 per cent in May and further to 10.3 per cent in June on account of a decline in non-administered fuel prices. Non-food manufactured products inflation was at 4.8 per cent in May and June 2012. However, input price pressures persist due to both exchange rate movements and supply side constraints.

The baseline projection for WPI inflation for March 2013 was raised from April projection of 6.5 per cent to 7.0 per cent because of Below average monsoon Rupee depreciation increasing import prices Domestic petrol prices are below international prices. This has led to suppressed inflation. An increase in petrol prices to international levels will increase inflation

Monetary and liquidity conditions: Liquidity conditions eased considerably since the April Policy. This turnaround was due to a decline in government cash balances with the Reserve Bank, injection of liquidity of about Rs. 860 billion by way of open market

Monthly Knowledge Series @ FinStreet: July 2012

Monetrix, MDI Gurgaon

operations (OMOs) and increased use of export credit refinance facility by banks after the increase in the limit effected in the June Mid-Quarter Review.

II.

Policy Move: a. Repo rate, CRR and MSF remained unchanged since the previous policy move b. SLR was reduced to 23% from 24% of NDTL

III.

Expected Outcome: The reduction of SLR is expected to ensure that liquidity pressures do not constrain the flow of credit to the productive sectors of the economy. This will allow banks to shift their portfolio in favor of the private sector. This is also an indication to the Government that they must start taking initiatives and not rely on RBI for Indias future growth surge.

Monthly Knowledge Series @ FinStreet: July 2012

Monetrix, MDI Gurgaon

Other Major RBI Policy Measures in 2012: 1. Priority Sector Lending Report (Feb 2012): The Reserve Bank of India (RBI) has issued the Nair committee report which has recommended the priority sector lending (PSL) limit for foreign banks be increased from 32% to 40% and changes be made in the classification of priority sector loans (direct & indirect agricultural loans, SMEs etc.). The RBI has asked suggestions comments from the participants on the report and final guidelines are likely to come later in FY13. 2. Final Basel III Guidelines (May 2012): In May, the RBI released the final guidelines for Basel III implementation in India. These guidelines would become effective from January 2013 in a phased manner. The Basel III capital ratios will be fully implemented by March 2018. The guidelines require a tier 1 common equity to risk weighted assets ratio of 8.0% (including 2.5% counter cyclical buffer), as against global guidelines of 7.0%. The guidelines have been lauded by credit rating agencies as more strict and conservative compared to global norms. Banks will need to raise US$20-30 Bn over the next five years to meet the new capital accord norms. Most banks should not face much difficulty in the transfer to Basel III norms. However, some of the weaker public sector banks with low return on assets and structurally weak balance sheets may face trouble, resulting in loss of market share and consolidation. 3. Hike in Export Credit Refinance Limit from 15% to 50% (June 2012) With a view to enhance credit flow to the export sector, the Reserve Bank of India (RBI) hiked the limit on export credit refinance from 15% to 50% of the outstanding rupee export credit for banks. While the move is expected to inject Rs.30000 Cr into the system, it is not expected to a have large impact on the liquidity situation as the high cost of funds shall remain a concern. However, it may be an incentive for dollars to come into the economy and result in the strengthening of the rupee. 4. Introduction of Tighter CDR Provisioning Norms (July 2012): Following a 156% Y-o-Y increase in the value of corporate debt restructuring (CDR) cases in FY12, a working committee of the RBI has issued new guidelines on CDR cases. The new provisions require the provisioning of an additional 3% in the first year and 5% in the second year. These will likely have a large negative impact on the profitability of most PSBs, excluding SBI, which has a relatively small restructured book (among PSBs). Private Banks should be marginally affected.