Monetary policy

IMPACT ANALYSIS

The Second Quarter Review, 2010-11

November 2010

Highlights of the Policy

• Repo and reverse repo rate raised by 25 bps each, to 6.25 per cent and 5.25 per cent, respectively,
with immediate effect.

• Cash reserve ratio (CRR) kept unchanged at 6.0 per cent.

• Real gross domestic product (GDP) growth forecast retained at 8.5 per cent for 2010-11.

• The baseline projection for wholesale price index (WPI) inflation with the new base of 2004-05
placed at 5.5 per cent for end-March 2011, which is equivalent to 6.0 per cent projected earlier
under the old series.

• Money supply and non-food credit projections retained at 17.0 per cent and 20.0 per cent,
respectively, for 2010-11.

• The loan-to-value (LTV) ratio with respect to housing loans should not exceed 80 per cent.

• Risk weight for residential housing loans of Rs 75 lakh and above, irrespective of the LTV ratio,
increased to 125 per cent.

• Increase in the standard asset provisioning by commercial banks for housing loans offering teaser
rates, to 2 per cent.

• Proposal to release draft guidelines with respect to grant of bank licenses to private sector players
in the public domain by end-January 2011.

• Proposal to put out a discussion paper on deregulation of interest rates on savings deposits by end-
December 2010.

• Increased the threshold limit for RTGS transactions to Rs 2 lakh from the present limit of Rs 1 lakh.
 Overview
Continued fight against inflation
In its mid-quarter review on September 16, 2010, the RBI had stated that its tightening measures “had
brought the monetary situation close to normal” and actions thereafter would depend on the prevailing and
expected macroeconomic situation. Today’s hike in repo and reverse repo rates by 25 basis points each,
indicates that while the RBI is confident on the growth front, it is not satisfied with the progress on
inflation.

Although industrial growth has begun to moderate, credit offtake remained slow in the first half of 2010-11
and there is no strong evidence of a general demand pressure on core inflation (non-food manufacturing
inflation). Yet, the RBI chose to raise the policy rates. The decision also partly reflects how the
macroeconomic scenario, the nature of global risks and the pattern of inflation have complicated the task of
monetary management.

Disaggregated analysis of WPI data reveals that the structural component (linked to changes in dietary
habits and poor supply response) may not be affected to a large extent by the good rains this year.
Therefore, inflation in food items such as meat, eggs, milk, could remain sticky. However, inflation in
cereals and pulses (which primarily spiked due to a supply shock from poor monsoons) is declining at a
faster pace. In September 2010, inflation in food grains stood at 6 per cent, a sharp deceleration from the
above 9 per cent inflation seen in the preceding months. Food-led inflation is typically difficult to address
directly through monetary tightening measures. Monetary tightening can, at best, address the second-round
effects of stubborn food inflation spilling to other sectors via the wage price spiral.

Further, the rate hikes will also limit the transmission of high raw material inflation into the manufacturing
sector. In September 2010, inflation in some raw materials such as metallic minerals stood at 60 per cent,
non-coking coal at 16 per cent and coking coal at 13 per cent. The continued easing in monetary conditions
in the developed countries can also exert pressure on commodity/oil/metal prices, going ahead. Today’s
rate hike will complement the transmission of previous hikes and pre-empt the supply shock on inflation
driven by external conditions. Moreover, the rate hike will also help in containing inflationary expectations
which remain high as per the household expectation surveys conducted by the RBI.

The move to raise risk weightage on housing loans beyond Rs 75 lakh, cap the loan-to-value ratio to 80
per cent and asset provisioning for teaser loans, will ensure prudence in lending to the real estate sector and
also help keep a tab on speculation.

Dharmakirti Joshi
Chief Economist, CRISIL

CRISIL RESEARCH MONETARY POLICY IMPACT ANALYSIS, NOVEMBER 2010 1

 Impact on the Economy and Banking Sector
Inflation control proves to be RBI’s main concern
Chart 1: Fifth rate hike this fiscal
In the backdrop of a complex macroeconomic scenario, the Reserve Bank of
%
India (RBI) met today for the second quarter monetary policy review. 10
Continuing with its calibrated approach of monetary tightening, the RBI once
again hiked repo and reverse repo rates by 25 bps each, to 6.25 and 5.25 per 8

cent, respectively. With the economy facing persistently high inflation along
6 CRR=6%
with appreciation in the rupee due to a deluge of capital flows, the RBI’s
decision today was indeed a tough one. However, inflation control once again 4 Rep o =6 .2 5%
proved to be the dominant concern for the Central Bank, notwithstanding signs
of moderating industrial growth and sharp ascent in the currency. 2
Reverse Repo= 5.25%

Mixed news on the inflation front 0

In spite of moderating in the last couple of months, the headline inflation still Ap r-0 8 Sep -0 8 Feb -0 9 J ul-0 9 Dec-0 9 M ay-10 Sep -10

remains high and much above the RBI’s comfort zone. Primary article inflation, Source: RBI
which remained stubbornly high at 19 per cent and contributed nearly 45 per
Chart 2: Inflation continues to be the main worry for
cent to overall inflation in the first half of 2010-11, is the main driver of
RBI
inflation and continues to remain around 17 per cent currently. However, the
slowing pace of non-food manufacturing inflation (core inflation) indicates the No n-Fo o d M fg Fo o d (Prim + M fg ) Overall WPI
y-o -y%
lack of generalised demand-side pressures. Irrespective of the mixed signals 2 5.0
emerging from the current inflation scenario, with today’s hike, the RBI 2 0 .0
indicated its discomfort with the prevailing inflation rate and concerns of
15.0
second-round effects of persistently high food and raw material inflation
10 .0
spilling over to other sectors of the economy.
5.0

Comfort on the growth front 0 .0

Industrial growth has become increasingly volatile in the recent months (Chart -5.0
3), raising doubts about its ability to reflect the underlying momentum in the
industrial sector - a fact acknowledged by the RBI as well. The agriculture
sector, however, has been buoyed by the good monsoons this year, while all Source: Ministry of Industry and CRISIL computations
leading indicators point to a sustained growth in the services sector too. Hence,
the domestic economy is on a strong footing this fiscal without any excessive Chart 3: IIP growth moderates amidst volatility
harm from the current cycle of monetary tightening. IIP Avg (FY0 4 -FY0 8 )
y-o -y%

Tight liquidity sets perfect backdrop for RBI’s monetary tightening stance 20

The transmission of interest rate hikes (initiated by the RBI since March 2010) 16

into the general interest rates have now gained pace under tight liquidity 12

conditions. Barring few weeks in August and September, liquidity largely 8

remained constrained in the second quarter, thus making repo rate the main 4
operative policy rate. Importantly, the effective increase in policy rate by 275 0
bps since March 2010 has strengthened the monetary transmission in the
-4
economy. However, to prevent the excessive deficiency in liquidity, the RBI
took some temporary liquidity-easing measures over the weekend. While this
will help to ease the liquidity situation slightly, going forward too, it is broadly
expected to remain tight since currency in circulation would continue to rise as Source: CSO & CRISIL estimates
the festival season begins. Nonetheless, the Central Bank’s unsterilized Chart 4: Tight liquidity in the system
intervention in the forex market in the future to stem the rupee’s sharp Net LAF trans actio ns , Rs b n (LHS) Call rat es Rep o rate Reverse rep o rate

appreciation coupled with the draw down of government balances could also 2000
%
11
ease the liquidity situation a bit.
10 0 0 9

10-year G-sec crosses the 8 per cent mark once again 0 7

After remaining rangebound around sub-8 per cent levels in the second quarter -10 0 0 5
of 2010-11, the yield on the benchmark 10-year G-sec crossed the
-2 0 0 0 3
psychological hurdle in the second week of October and has been trading
between 8.0-8.1% since then. The impact of the RBI’s monetary tightening -3 0 0 0 1

stance has been felt largely across the short-term yields. Going forward, yields
are expected to stay somewhere around their current levels due to the netting of
FY10 FY11
the upward and downward pressure on the 10-year yield in the near term.
Source: RBI and CCIL

CRISIL RESEARCH MONETARY POLICY IMPACT ANALYSIS, NOVEMBER 2010 2

Upward pressure on lending rates
The 25 bps hike in repo and reverse repo rates is expected to be transmitted to the Chart 5: Yield curve flattens
banking sector in the form of higher cost of funds. In response to rate hikes that have %
12
taken place during the course of the year, most of the banks have already increased their
lending rates by 25-50 bps in the first week of October 2010. With the cost of funds for
banks expected to increase further, CRISIL Research expects an increase of about 25 bps 9

in lending rates in the second half of 2010-11.

6
Tightening of regulation on housing loans
In view of the risks emanating from the housing loan portfolio of banks, the RBI has
proposed the following guidelines: 3

(a) The loan-to-value ratio should not exceed 80 per cent to prevent excessive
leveraging by banks. At present, there is no regulatory ceiling on the loan-to-
1yr G-s ec 10 Yr G-sec
value ratio in respect of banks’ housing loan exposures.
(b) The bank provisioning for teaser loans should be increased to 2 per cent from Source: CCIL
the current 0.4 per cent, owing to the high risk nature of such loans. Chart 6: Growth in advances and deposits
(c) The risk weight for residential housing loans of Rs 75 lakh and above should 3 5%
be increased to 125 per cent, irrespective of the loan-to-value ratio. At present,
30%
the risk weights on residential housing loans with loan-to-value ratio up to 75
2 5%
per cent, are 50 per cent for loans up to Rs 30 lakh, and 75 per cent for loans
20%
above that amount. In case the loan-to-value ratio is more than 75 per cent, the
15%
risk weight of all housing loans, irrespective of the amount of loan, is 100 per
10 %
cent.
5%
Credit growth of about 20 per cent expected in 2010-11 0%
The aggregate y-o-y bank credit growth of 21.6 per cent as on July 2, 2010 (on account
of large borrowings for 3G spectrum and broadband wireless access auctions) decreased
Dep o sit g ro wth Ad vances g ro wth
to 20 per cent as on October 8, 2010. Credit growth is expected to be about 20 per cent
for 2010-11 as high capacity utilisation levels will require capital investments, and Source: RBI and CRISIL Research
increase in infrastructure credit disbursements for projects where sanctions have been
Chart 7: Credit deposit and Incremental CD ratio
received. Also, given the festive and agricultural harvest seasons in the second half of
the year, credit growth is expected to remain stable. 12 0 .0 %

10 0 .0 %

Deposits to grow by 16-18 per cent in 2010-11 8 0 .0 %

Despite hike in deposit rates by 50 bps (on an average) in the first half of 2010-11, the 6 0 .0 %
deposit growth rate has been 14-15 per cent till October 2010. The annual deposit
4 0 .0 %
growth stood at 15.0 per cent as on October 8, 2010, after peaking at 17.1 per cent on
2 0 .0 %
March 26, 2010. This is primarily because investors preferring to channelise their
savings to other avenues on account of negative real interest rates on bank deposits. For 0 .0 %

inflows to revive, the deposit rates will need to be more attractive. Realising this, several
banks increased their deposit rates by a further 25-75 bps in the first week of October.
Cred it -d ep o s it ratio Incremental Cred it-d ep o s it ratio
Consequently, the deposit growth rate is expected to reach 16-18 per cent by end 2010-
11. Source: RBI and CRISIL Research

Incremental credit-deposit ratio to reach 80 per cent in 2010-11 Table 1: Sector-wise bank credit growth
Moderation in credit offtake and stable growth in deposits had resulted in the Growth, y-o-y %
incremental credit-deposit ratio declining to 92.3 per cent on October 8, 2010, from 99.9 Personal
per cent on July 2, 2010. CRISIL Research expects the incremental credit-deposit ratio Industry Services Loans Infrastructure
for 2010-11 to decline further to 80 per cent from these levels, mainly on account of the
2QFY09 30.6 35.3 17.4 35.8
expected improvement in growth of deposits.
3QFY09 30.2 27.6 14.6 38.5
CRISIL macroeconomic forecast for 2010-11 4QFY09 25.8 19.2 8.5 35.1
Parameter Forecast 1QFY10 21.2 20.5 5.5 35.1
Agriculture 5.5
2QFY10 17.9 11.0 2.3 44.7
Industry 8.6
Growth (%) 3QFY10 14.2 7.9 0.7 47.2
Services 8.8
Total GDP 8.2 4QFY10 20.1 15.0 4.7 42.3
Inflation (%) WPI Average 8.0-8.5 1QFY11 25.8 14.1 6.5 44.3
Interest Rate (%) 10-year G-sec (Year-end) 8.1-8.3
2QFY11 29.2 21.0 8.9 55.0
Exchange Rate Re/US$ (Year-end) 43.5-44.0
Source: RBI and CRISIL Research
Fiscal deficit Fiscal Deficit (as a % of GDP) 5.0

CRISIL RESEARCH MONETARY POLICY IMPACT ANALYSIS, NOVEMBER 2010 3

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