Rama Krishna Vadlamudi, BOMBAY January 29, 2010

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Shift in policy stance from ‘MANAGING THE CRISIS’ to ‘MANAGING
THE RECOVERY’
What are the implications for stock market and the Indian economy?
EXECUTIVE SUMMARY OF THE THIRD QUARTER REVIEW:
Monetary policy documents usually tend to be full of jargon and round-about
expressions. Mr. D. Subbarao after taking over as RBI Governor just before the Lehman
Brothers collapse has brought some sort of freshness, clarity and transparency in
language, form and intent to the policy documents in the last 18 months of his able
leadership. One refreshing feature about the third quarter review of monetary policy
2009-10 is its crispness. What ever the RBI Governor wants to convey has been conveyed
in a succinct manner in the third quarter review of the policy.
Around 11.00 this morning, RBI announced its third quarter review of monetary policy
2009-10. Now, let us see what the RBI Governor has set out in the policy for the
economy. As expected, there was a hike in cash reserve ratio (CRR) and there is no hike
in the LAF-Repo Rate and LAF-Reverse Repo Rate. But, what surprised the market was
the 75-basis point (0.75 per cent) hike in CRR from the present 5.00% to 5.75%. The days
of cheap money policy are over and we have entered an era of dear money policy.
RBI is telling that the Indian economy is recovering fast and it has raised its GDP growth
forecast to 7.5 per cent for 2009-10. It is very optimistic about GDP growth rate. It has
raised the WPI inflation forecast to 8.5 per cent by the end of March 2010. It has reduced
its projections for money supply, deposit and loan growth for 2009-10. It has expressed
concern about the slow recovery in the world economy which, it feels, will have some
adverse impact on our growth prospects. It expects the Government go give a clear
roadmap for withdrawing fiscal stimulus. It wants the Government to return to the path
of fiscal consolidation (meaning that Government should bring down fiscal deficit.). RBI
does not want to upset the apple cart of India’s growing economy. It does not want to
hamper the growth in consumer spending and private sector investment. As such, it has
postponed the increase in interest rates for the time being. At present, it is taking out only
excess liquidity by raising CRR. As RBI rightly put it, it wants to move from ‘Managing
the Crisis’ to ‘Managing the Recovery.’ The details of the policy are given below:
 Rama Krishna Vadlamudi, BOMBAY January 29, 2010
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Highlights of the Third Quarter Review of the Monetary Policy

1) Cash Reserve Ratio has been increased from 5.00 per cent to 5.75 per cent. This is
being done in two stages. In the first stage, the increase will be 50 basis points to
5.50 per cent effective February 13, 2010. In the second stage, the increase will be
25 bp from 5.50 per cent to 5.75 per cent of their net demand and time liabilities
(NDTL) with effect from February 27, 2010.
2) The LAF-Repo Rate has been kept unchanged at 4.75 per cent
3) The LAF-Reverse Repo Rate has been kept unchanged at 3.25 per cent
4) The Bank Rate has been retained at 6.00 per cent
5) The Savings Bank Rate has been retained at 3.50 per cent

RBI’s GROWTH FORECAST:

The following are the growth forecasts for various indicators as per the third quarter
review of monetary policy:

GDP growth for 2009-10 has been revised to 7.5 per cent (from 7 per cent earlier).
Interestingly, this is in sharp contrast to 6.9-per cent growth projection given by
professional forecasters’ survey conducted by RBI and announced yesterday.

WPI inflation is expected to touch 8.5 per cent (from 6.5 per cent projected earlier)
by end-March 2010

Indicative projection for deposit growth rate is reduced to 17 per cent (from 18 per
cent earlier)

Indicative projection for loan growth is reduced to 16 per cent (from 17 per cent
earlier)

Indicative projection for M3 growth is cut to 16.5 per cent – RBI maintains these are
only indicative projections, but should not be construed as RBI’s targets

IMPACT OF THE POLICY MEASURES

I. IMPACT ON LIQUIDITY:

We have seen a long period of excess liquidity, ranging from Rs 70,000 crore to Rs
1,40,000 crore, in the banking system in the last nine months. (This does not include
Government’s surplus kept with the RBI.) RBI is behind the curve and it wants to make
up for the lost time. As such, it raised the CRR by 75 basis points suddenly. A 75-bp hike
in a single instance has never been attempted by RBI in the last 10 years. The two-stage
hike in CRR will suck out liquidity to the tune of Rs 36,000 crore from the banking
system by the end of February 2010. Coupled with the Advance Tax outgo in the middle
of March 2010, a substantial portion of the excess liquidity would have been taken out by
the end of March 2010.

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 Rama Krishna Vadlamudi, BOMBAY January 29, 2010
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II. IMPACT ON MONEY MARKETS:

With tightening of liquidity, short-term money will become costlier as short-term rates
for certificate of deposit, commercial paper, treasury bill, etc, will go up. As such, one
can expect better returns from liquid/money market mutual funds. At this point of time,
they have been giving returns in the range of 4.50 and 5.00 per cent. The returns from the
liquid/MMMFs will go up gradually to between 5.25 and 5.50 per cent in the next few
months. However, as money supply will be tight, the net assets of mutual funds will be
under pressure in the next few months.
(Liquid funds offer much better returns compared to Savings Bank accounts. If you want to invest your
short-term surplus in liquid mutual funds, you can read my article at:)

Good Liquid or Money Market Mutual Funds

www.scribd.com/doc/23073415
III. IMPACT ON BOND MARKET:
Bond market was expecting a 50-basis point raise in CRR. But, when RBI raised CRR by
75 bp, the market reacted negatively in the initial stage and yields were hardened by five
basis points from 7.68 per cent to 7.73 per cent. Later, they absorbed the policy action
and at the time of writing this article, the 10-year benchmark (6.90% GS 2019) yield
retraced back to 7.69 per cent. In future, bond markets will remain stable as international
crude oil price is down to USD 73.5/barrel from levels of USD 85/barrel two weeks ago.
With huge pipeline of PSU disinvestment programme by the Central Government, the
pressure on fiscal deficit will be lesser going forward. And then there is this auction of
3G spectrum to telecom companies, through which Government wants to raise about Rs
35,000 crore. However, much will depend on tax collections and the borrowing
programme of the Central Government which will be announced when the Union Budget
is presented on February 26, 2010.
IV. IMPACT ON STOCK MARKET:
Benchmark index, Sensex, has lost 10 per cent in the last seven to ten days due to
expectations of rate hike by RBI, poor quarterly results from some bellwether companies
(like, Larsen & Toubro, HUL, M&M, HCL Technologies) and weak global indications
which were worsened by comments from the US President, Barack Obama, who wants to
put curbs on proprietary trading done by big banks in the US and hedge fund activities.
After the RBI announcement of the policy, Sensex went down up to minus 300 points
(over previous day’s close) and recovered later. At the time of writing this article, the
Sensex was flat at 16,300. After a loss of about 10 per cent in the last one week or so, one
may not see much weakness in the stock indices going forward due to RBI’s CRR hike.
Some companies – like, Maruti Suzuki, Asian Paints, Reliance Industries, Hero Honda,
Axis Bank, BHEL, Tata Steel, Infosys, TCS, Wipro – have posted good to excellent
quarterly results. But, as is its wont, stock market has ignored these positive results and
focused more on negative numbers.

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 Rama Krishna Vadlamudi, BOMBAY January 29, 2010
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Interestingly, in the last round monetary tightening from October 2004 to August 2008,
when YV Reddy was at the helm as RBI Governor, Sensex had gone up from 5,600-level
to 14,500-level, a spectacular rise of 160 per cent in a little less than four years. In this
context, is it correct to say that monetary tightening will stunt growth in the economy and
corporate profits? I have my own doubts. Of course, excessive raise in interest rates will
dampen GDP growth as had happened when YV Reddy raised interest rates in the latter
part of 2007 and early part of 2008. This monetary tightening had resulted in the sudden
slump in GDP growth rate to 7.80 per cent in the first half of 2008-09 and further to 5.80
per cent in the second half of 2008-09 which was much less than 9.0 per cent growth
levels achieved in 2007-08. To be fair to Mr YV Reddy, I would like to add that there are
other reasons for the sudden slump in GDP growth to 6.70% in 2008-09.
Of course, those times, the prospects, circumstances and the context were different. As
we have seen here, the argument that monetary tightening is detrimental to economic
growth is rather specious and fallacious on the face of it. The notion that dear money
policy (that is, rising interest rate scenario) from RBI will hamper growth needs further
investigation. Having said that, I would like to add that rising interest rates will have
adverse impact on interest rate-sensitive sectors, like, automobiles, housing finance,
housing, real estate, etc. Banks may weather the rising rate scenario in a better manner as
they will concentrate more on protecting their net interest margins (NIMs) by raising the
deposit and loan rates. Of course, banks may not raise loan rates immediately.
If RBI raises repo rate, then banks will seriously consider raising interest rates. However,
the sluggish credit growth may prove to be more tricky for banks to raise their interest
rates on loans. If the credit off-take picks up, banks are likely to start raising loan rates.
The mandatory 70-per cent provisioning coverage and rising NPAs in the books of banks
will put the stock markets on edge for some more time. One more important thing is that
the rise in CRR will bring down the returns banks earn on their assets as they have to
keep this extra CRR money with RBI at zero per cent interest.
V. IMPACT ON INDIAN ECONOMY: The period of accommodative monetary
policy has come to an end and the excess liquidity is going to be taken out by the end of
March 2010. As mentioned above, it will have negative impact on rate-sensitive sectors.
RBI has to make some tough decisions to achieve its twin objectives of making credit (at
reasonable rates) available for supporting growth while anchoring inflationary
expectations in the economy. The economy can easily absorb the 75-bp hike in CRR for
now, as there is more surplus money with banks. Private sector in India is more
dependent on FCCBs, FDI, IPOs, private equity and QIPs rather than bank credit.
RBI is concerned that the slower economic recovery at the global level may impact
India’s economic prospects adversely. It is also concerned about the food inflation which
is at 17.5 per cent at this point of time. RBI is closely watching the progress of south west
monsoon also. It has also expressed its concern on large capital inflows into the Indian
economy beyond the level of absorption by Indian economy. It says that these capital
inflows may complicate monetary management and exchange rate policy.

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 Rama Krishna Vadlamudi, BOMBAY January 29, 2010
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RBI in its policy has strongly advocated a policy of reining in India’s huge fiscal deficit,
which is around 13 per cent of the GDP, much above the FRBM’s targets. (Please don’t
believe the Government’s official figure of 6.8 per cent fiscal deficit!) RBI has indicated, in
no uncertain terms, that the Central Government should indicate its roadmap for
withdrawal of fiscal incentives; tax policies are to be spelt out clearly; and unnecessary
expenditure should be curbed. It remains to be seen how the Government will respond to
RBI’s strong overtures in this regard. Even the 13th Finance Commission, which submitted
its report to the Government recently, has suggested that India should return to a path of
fiscal consolidation immediately in the next two years.

Why did RBI choose to raise CRR, but not Repo Rate?

Interestingly, RBI chose to raise only CRR now. It has refrained from raising interest
rates by keeping both the Repo and Reverse Repo at historically low levels. So, why did
RBI opt to raise only CRR, but not Repo/Reverse Repo rates now? To know the answer,
we need to go back a little in time. If you analyse the rates in the last decade we can see
that whenever the CRR was between 5.50 and 6.00 per cent, the Repo and Reverse Repo
rates were kept at much higher levels. RBI’s actions in the last decade indicate that
whenever there is increase/decrease in reserve ratios (CRR & SLR), there is an associate
increase/decrease in policy ratios (bank rate, repo rate and revere repo rate) or vice versa.
Of course, there could have been a little time lag between RBI’s actions.
CRR was last revised wef January 17, 2009 when it was reduced from 5.50 per cent to
5.00 per cent. Repo and Reverse Repo rates were last revised wef April 21, 2009 when
they were reduced from 5.00 per cent to 4.75 per cent and from 3.50 per cent to 3.25 per
cent respectively. Bank rate has not been revised since April 2003.
For example, CRR was at 5.50 per cent in November 2008 and at that time repo and
reverse repo rates were at 7.50 and 6.00 per cent respectively. In February 2007, CRR
was at 5.75 per cent; whereas, repo and reverse rates were at 7.50 and 6.00 per cent
respectively. This clearly shows RBI has been behind the curve (Meaning monetary
policy action is a bit slow in response to rising inflation and higher GDP growth forecast
– Of course, the years 2008 and 2009 were very challenging for central banks around the
world due to the global financial meltdown and as such RBI was justified in keeping the
policy rates very low as it wants to play safe and not stifle the economic recovery in the
nascent stage.). Now, with a steep and sudden 75-bp increase in CRR today, RBI wants
to move fast as it no longer wants the excess liquidity feeding inflationary pressures.
Now, if you see while the CRR is at 5.75%, the Repo and Reverse Repo rates are at
4.75% and 3.25% respectively. RBI has delayed the hike in interest rates as it wants to
regulate the exit of expansionary policies in a smooth manner. It does not want to give
any sudden shocks to the economy. This reassurance is good for the economy. However,
we need to watch how the monetary exit will be coordinated with the withdrawal of
excise duty concessions and service tax reduction by the Government. We may look for
some indications about that in the next Union Budget on February 26, 2010.

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 Rama Krishna Vadlamudi, BOMBAY January 29, 2010
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RBI’s policy of holding interest rates for now is in tune with the expectations of the
Government. As we have seen in the last six months or so, policymakers at the Central
Government have been cautioning, directly and indirectly, the RBI not to raise interest
rates immediately as the economy recovery is in early stages. The Prime Minister and
Finance Minister have spoken in this regard and expressed that monetary and fiscal
incentives are likely to be continued for some more time. Even Montek Singh Ahluwalia,
deputy chairman, Planning Commission, and Kaushik Basu, the new Chief Economic
Advisor in the Finance Ministry have cautioned against any immediate withdrawal of
fiscal as well as monetary stimulus. Only the chairman of the PM’s Economic Advisory
Council, C Rangarajan, has been consistently advocating rate action from RBI. Even SS
Tarapore, former RBI Governor, has been a staunch advocate of dear money policy for
some time.

More over, the Union Government wants to divest its stake in PSUs, especially, NTPC
and others. At this point of time, the Government does not want to upset the stock
markets. It wants to raise money for itself at much better prices for its stake sale.

What is the outlook for interest rates?

As explained before, RBI has got a lot of catching up to do with country’s growth
estimates and rising inflationary concerns and accordingly it has raised its forecast for
GDP growth and inflation rate significantly. Sooner than later, it will have to increase
repo and reverse repo rates by at least 150 basis points. This will be done in a gradual
manner in the next six to nine months. However, we can anticipate that RBI will have to
raise repo and reverse repo rates by at least 25 basis points by the end of February 2010,
by which time Union Budget and third quarter GDP figures would have been out. Of
course, RBI will be watching closely wholesale price index as well as food inflation, in
addition to GDP, IIP growth figures (3rd quarter GDP figures will be announced on
February 26, 2010.) And it will be monitoring the progress of actions from other central
banks, like, US Fed, BoE and ECB.

The policy is, more or less, in tune with the expectations of the financial markets. Though
it is slightly behind the curve, it wants to balance its twin objectives of price stability and
making credit available for supporting growth in a way that is in line with the objectives
of fiscal policy and the Government’s policies. RBI has said that it will support the
growth recovery process without compromising on inflation. One comforting factor for
the RBI is the deep correction (of about 13 per cent in international crude oil prices) in
crude oil price to USD 73.50/barrel at this point of time. Any sudden spike in the oil
prices to USD 100/barrel or beyond will pose serious challenges to RBI and the Indian
economy.

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 Rama Krishna Vadlamudi, BOMBAY January 29, 2010
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ABBREVIATIONS USED:
BoE : Bank of England
CRR : Cash Reserve Ratio (the money banks have to keep
statutorily with RBI – RBI does not pay any interest on
CRR money kept by banks)
ECB : European Central Bank
FCCB : Foreign Currency Convertible Bond
FDI : Foreign Direct Investment
FRBM : Fiscal Responsibility and Budget Management Act
IPO : Initial Public Offer
LAF : Liquidity Adjustment Facility (RBI uses this facility to
withdraw excess liquidity from banks or inject liquidity
into banks when they need it)
LAF-Repo Rate : The rate charged by RBI to banks for lending its overnight
money to banks
LAF-Reverse Repo Rate : The rate paid by RBI to banks for keeping banks’
surplus funds overnight with RBI
NPAs : Non-Performing Assets or bad loans in banks’ books
QIP : Qualified Institutional Placement
RBI : Reserve Bank of India
SLR : Statutory Liquidity Ratio
US Fed : US Federal Reserve
WPI inflation : Inflation based on wholesale price index

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