IBS Hyderabad 2011

Ainesh Mukherjee 10BSPHH010047 SECTION-G

The Policy Rate Hike in India- Good or Bad News

With lending rates rising, fears of banks asset quality deteriorating are gaining ground. In such conditions, banks should improve their bad loan management system. K C Chakrabarty, deputy governor, Reserve Bank of India (RBI). The RBI has continued its upward interest rate revision policy of the past one year by yet again hiking the interest rates by 50 basis points recently. The new repo rate is 8% and the corresponding reverse repo rate (1% lesser than repo rates) is 7%. This in effect will mean that things are going to be costlier on the borrowing front.

An Overview of the Current Situation

The Indian Banking Sector has undergone some major changes in the last fiscal year and such changes have seemed to be inevitable for this quarter of the fiscal as well. The Central Bank has increased rates 10 times in the last 15 months and this revision in the rates adds to the list further. Though these measures are being taken to curb the inflationary trend prevailing in the Indian economy, economists and market watchers still found the wholesale price index based inflation above the central banks comfort zone. Even before the revision of rates took place on the 27 th of July, 2011, economists were of the opinion that there will be a 25 basis points increase but the sudden 50 basis points rise has taken everybody by a shock. With such revision, the fear of Non Performing Asset (NPA) management by banks has fiercely crept in which is a bad signal for the entire financial sector complimented with possibilities of low growth in the coming few months.

Some Important Macro Economic Rates

Bank rate: Bank Rate is the rate at which central bank of the country (in India it is RBI) allows finance to commercial banks. Bank Rate is a tool, which central bank uses for short-term purposes. Any upward revision in Bank Rate by central bank is an indication that banks should also increase deposit rates as well as Prime Lending Rate. This any revision in the Bank rate
IBS | The above case study is a compilation of data extracted from The Business Standard, bankbazaar.com and the internet. This document is meant only for academic purposes in IBS Hyderabad and has been compiled by Ainesh Mukherjee- a student of the college. 1

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indicates could mean more or less interest on your deposits and also an increase or decrease in your EMI. CRR: The Reserve Bank of India (Amendment) Bill, 2006 has been enacted and has come into force with its gazette notification. Consequent upon amendment to sub-Section 42(1), the Reserve Bank, having regard to the needs of securing the monetary stability in the country, can prescribe Cash Reserve Ratio (CRR) for scheduled banks without any floor rate or ceiling rate. [Before the enactment of this amendment, in terms of Section 42(1) of the RBI Act, the Reserve Bank could prescribe CRR for scheduled banks between 3 per cent and 20 per cent of total of their demand and time liabilities]. RBI uses CRR either to drain excess liquidity or to release funds needed for the economy from time to time. Increase in CRR means that banks have less funds available and money is sucked out of circulation. Thus we can say that this serves duel purposes i.e. it not only ensures that a portion of bank deposits is totally risk-free, but also enables RBI to control liquidity in the system, and thereby, inflation by tying the hands of the banks in lending money. SLR: Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). Present SLR is 24%. (reduced w.e.f. 8/11/208, from earlier 25%) RBI is empowered to increase this ratio up to 40%. An increase in SLR also restricts the banks leverage position to pump more money into the economy. What is Repo rate and Reverse Repo rate? (Policy Rates) Repo rate is the rate at which the RBI lends shot-term money to the banks. When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI. The RBI uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the RBI will borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep their money with the RBI Thus, we can conclude that Repo Rate signifies the rate at which liquidity is infused into the banking system by the RBI, while the Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks. They are known as policy rates and possess huge significance as macro economic indicators. Normally the RBI uses these rates to curb inflation and increase or decrease the industry and infrastructure spending and investment.
IBS | The above case study is a compilation of data extracted from The Business Standard, bankbazaar.com and the internet. This document is meant only for academic purposes in IBS Hyderabad and has been compiled by Ainesh Mukherjee- a student of the college. 2

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Reasons for The Rate hike
The hike has been forced probably due to 2 major reasons: 1. A continued rise in the prices of non-food manufactured products and the rising Crude oil prices. 2. There is also considerable indication that business growth is moderating. Thus, the RBI has deemed it necessary to continue its anti-inflation policy and continue with raising interest rates. Over the last 15 months, the RBI has raised the Cash Reserve Ratio (CRR) by over 100 basis points and the Policy rate by over 275 basis points. This in effect means that banks have to face a net effect pressure of around 425 basis points. This policy stance of the RBI in the past one year has meant that on an average, all banks/lenders have raised their deposit and Lending rates by over 225 basis points (2.25%). This means that loans have become costlier. Housing loan, car loan, personal loan etc have all borne the blunt of this upward rise. Although it must also be seen that deposit rates have gone higher too, the extra income that you get will be compensated by the extra you have to shell out for gas, oil, soap, food, etc.!

Indications
It is clear that the RBI is not keen on supporting growth without getting the necessary infrastructure in place. It is clear from all its recent communications that a major reason for inflation is the supply side inefficiency and it will do all that it can do on the monetary side to fight inflation tooth and nail and also manage/minimize the resulting negative effect on business growth. The RBI is also committed to ensuring that not all these policies result in a very negative effect on the liquidity situation. But how will this pan out in the coming days? 1. Loans will be costlier: A direct impact that can be felt in the coming few days is an inevitable rise in Interest rates charged by banks for their lending products including home loans and car loans.

2. Prices will mostly stagnate in the medium term: in the immediate short term, we may not see any major price changes in the day-to-day products we buy; in the medium-term,
IBS | The above case study is a compilation of data extracted from The Business Standard, bankbazaar.com and the internet. This document is meant only for academic purposes in IBS Hyderabad and has been compiled by Ainesh Mukherjee- a student of the college. 3

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there will be a stagnation of prices due to the anti-inflation measures that have been implemented in the last 20 months. 3. Cars and Homes may be costlier: Already faced with many pressures due to external factors, these two industries will take a direct hit of the current hikes. On one hand, their borrowings will get costlier leading to pressure on margins, and on the other hand since banks will charge more for loans, they could see a hit on the sales side too.

Reactions from the Government

Finance Minister Pranab Mukherjee dashed faint hopes of a pause in the Reserve Bank of Indias (RBIs) rate tightening cycle. Speaking to reporters a day after RBI stunned everybody with a 50 basis points (bps) increase in the repo rate, Mukherjee indicated this might not be the last increase.I dont think we have reached the end of the tunnel, Mukherjee said, when asked if RBI was nearing the end of the rate increase cycle.Yesterdays rate increase has drawn criticism from companies worried about higher borrowing costs and prompted economists to revise their growth outlook. Standard Chartered Bank has reduced its gross domestic product growth forecast for this financial year from 8.1 per cent to 7.7 per cent. Kotak has cut its growth forecast to 7.3 per cent from 7.7 per cent, among the lowest in the market.The benchmark 10-year bond yield on Wednesday hit its highest level in almost three years after rising 15 bps yesterday. Stocks continued their slide, losing nearly 0.5 per cent, and are down 10 per cent this year.RBI had said yesterday that its measure (repo rate increase) was expected to reinforce the point that there was an absence of complementary policy responses on both demand and supply sides. Admitting that the 9.4 per cent inflation in June was unacceptable, Mukherjee said high prices were a global phenomenon and the whole world was reeling under rising prices of fuel and other commodities.The government and RBI were taking steps to check inflation, he said, adding, I am optimistic that the measures taken by RBI by adjusting the crucial rate will have an impact and inflation will come down. The inflation, Mukherjee said, might not come down to below 6-7 per cent by the end of the current financial year. In an economy, Mukherjee said, You cannot have a carpet under which you can keep all these things and at the same time expect these things will remain stable. He said crude oil prices went up from $89 per barrel when the Budget calculations were done to $107-110 a barrel. He said he would take up the issue of volatility in commodity and crude oil prices at the international forum, including the G-20.

IBS | The above case study is a compilation of data extracted from The Business Standard, bankbazaar.com and the internet. This document is meant only for academic purposes in IBS Hyderabad and has been compiled by Ainesh Mukherjee- a student of the college.

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Meanwhile, the Financial Stability and Development Council, a body of the finance ministry and financial sector regulators, expressed confidence that the growth momentum would be maintained despite yesterdays steep repo rate increase. Meanwhile, BSE's 30-share Sensex fell 353.07 points or 1.87% to 18518. NSE's 50-share Nifty dropped 105.45 points or 1.86% to 5574.85. Across the broader market, losers beat gainers 1,887 to 1,000 on the BSE.

Fear of Increased NPAs in Banks

K.C Chakrabarty, deputy governor RBI, expressed a fear of increasing non-performing assets (NPAs), as interest rates rise. We are only warning banks that their NPA monitoring system should be better. Risks can be mitigated if banks are able to identify them earlier, he said. Pointing out the faults in outdated systems, he said there were enough gaps in the NPA monitoring processfrom identification to follow-up to recovery. The process needed to be accelerated, he said. Lately, NPA accretion has been more evident in the case of public sector banks, as they move to a system that identifies bad loans without human intervention. Deputy governor Subir Gokarn said a rise in the cash reserve ratio would not have been beneficial. It would disrupt normal business for banks. Since liquidity is already in deficit mode and policy transmission is better in such conditions, it was better to use a repo rate rise, he said. Gokarn added the cumulative impact of past rate rise actions would bring down inflation from the November-December period. In the first quarter policy review, RBI increased the inflation projection for the end of this financial year from six per cent to seven per cent. Inflation, as measured by the wholesale price index, stood at 9.44 per cent in June. Economists say the figure may touch double digits on revision. The rate rise created an arbitrage opportunity for global players, which was reflected in the appreciation of the Indian rupee by 22 paise against the dollar. RBI said it did not intervene with the objective to set the exchange rate. Exchange rates have to be market determined. If the rupee appreciates, it would have a positive impact on inflation, as imports would become cheaper, said Gokarn. On the governments borrowing plan, deputy governor H R Khan said RBI would take advantage of the flat yield curve and continue to sell more longer-dated papers. Higher government borrowing through cash management bills and treasury bills lifted yields at the shorter end, flattening the yield curve. RBI on Wednesday auctioned Rs 10,000 crore worth of treasury bills. It is set to auction Rs 12,000 crore of dated government securities on Friday.

IBS | The above case study is a compilation of data extracted from The Business Standard, bankbazaar.com and the internet. This document is meant only for academic purposes in IBS Hyderabad and has been compiled by Ainesh Mukherjee- a student of the college.

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Inflation v. Growth
Another issue that should be taken into discussion is the inflation v. growth factor. With the recession of 2008 just gone by, the Indian economy has to ponder upon the fact as to how far it could meddle with the policy rates especially when it cannot tolerate yet another recessionary trend. How are these related? When we do talk about the increase in policy rates which have now taken place, we have already discussed the impact it might have on industrial growth especially because an increase in lending rates would reduce the capital formation in the economy. Though, inflationary trends might reduce due to such measures, we might have just underestimated its impact on the index of industrialization. We have already seen the sensex falling drastically after the latest increases in policy rates have taken place. If this keeps happening, it would reduce the investors confidence in the economy. It might as well result in the reduction in FIIs and FDIs in the economy resulting in the attractiveness index for India going further down. Already, we have seen a reduction in FDIs and FIIs in this fiscal as compared to the last fiscal. Foreign institutional investors (FIIs), which have invested around $2 billion in Indian equities this year, seem to have taken serious note of the sharp increase in policy rates by the Reserve Bank of India (RBI) yesterday. While they remain bullish on Indias long-term prospects, they feel the recent rate increases by RBI have put the markets at an additional risk in the near term and delayed the break out from the current range. On the day when RBI increased repo and reverse repo rates by 50 basis points (bps), the Sensex fell more than 350 points. This was primarily attributed to the surprise element as the markets were expecting a 25 bps increase. The 30-share index lost another 86 points on Wednesday and closed at 18,432. Finance minister Pranab Mukherjee has warned that inflation may not be less than 6-7 per cent at the end of the year even as the government and RBI are making efforts to fight the rise in prices. Morgan Stanley went a step ahead and said the RBI move had stymied any probable breakout of the Nifty from its trading range. The case that may have been building for the Nifty to break out of its trading range since the fourth quarter of 2010 has probably been stymied by this move, it said. Morgan Stanley, however, remains a buyer of Indian equity with a 12- to 18-month investment horizon, adding that small- and mid-cap stocks are looking more attractive than the large caps. The global financial major is bullish on domestic cyclicals such as consumer discretionary and industrials. Goldman Sachs, meanwhile, is of the view that the equity market is still amid choppy waters and that stocks are not yet ready for an upturn.
IBS | The above case study is a compilation of data extracted from The Business Standard, bankbazaar.com and the internet. This document is meant only for academic purposes in IBS Hyderabad and has been compiled by Ainesh Mukherjee- a student of the college. 6

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It, however, adds that the repo rate has likely peaked for now and would remain stable before falling marginally by December 2012 to around 7.5 per cent. While we do not expect inflation/rates to collapse, we believe stocks may start outperforming as rates/inflation decline, even though the bottom is at higher levels vis--vis the past cycles, said Goldman Sachs. It expects inflation to bottom out at 4.9-5.1 per cent in the third quarter of 201213.

Conclusion
The RBI , through these rate hikes has significantly indicated what its policy would aim at. Inflation has now for a long time been a major concern for the entire economy and through a rise by 50 basis points, there definitely are chances that the current economic situation be resolvedbut the question is how far will it affect the industries and how far will it affect the general public? Also, the concern for NPA management and the falling sensex should not be allowed to destroy the financial and industrial structure of the Indian economy respectively. Thus the RBI is required to continuously evaluate the rate hikes and keep a check on other macro economic factors which might be affected due to such a sudden measure.

IBS | The above case study is a compilation of data extracted from The Business Standard, bankbazaar.com and the internet. This document is meant only for academic purposes in IBS Hyderabad and has been compiled by Ainesh Mukherjee- a student of the college.

IBS Hyderabad 2011 Exhibit 1

History Of Rate Hikes By Rbi:Repo rate 2/07/2010- Rbi increases rate to 5.5% 27/07/2010-- Rbi increases rate to 5.75% 16/09/2010-- Rbi increases rate to 6% 02/11/2010-- Rbi increases rate to 6.25% 25/01/2011-- Rbi increases rate to 6.5% 17/03/2011-- Rbi increases rate to 6.75% 03/05/2011-- Rbi increases rate to 7.25% 16/06/2011-- Rbi increases rate to 7.5% 26/07/2011-- Rbi increases rate to 8%. Reverse repo rate 2/07/2010- Rbi increases rate to 4% 27/07/2010- Rbi increases rate to 4.5% 16/09/2010- Rbi increases rate to 5% 02/11/2010- Rbi increases rate to 5.25% 25/01/2011- Rbi increases rate to 5.5% 17/03/2011- Rbi increases rate to 5.75% 03/05/2011- Rbi increases rate to 6.25% 16/06/2011- Rbi increases rate to 6.5% 26/07/2011- Rbi increases rate to 7%

*Source: RBI website

IBS | The above case study is a compilation of data extracted from The Business Standard, bankbazaar.com and the internet. This document is meant only for academic purposes in IBS Hyderabad and has been compiled by Ainesh Mukherjee- a student of the college.

IBS Hyderabad 2011 Exhibit 2

Bank Related Rates Type Policy Rate Name Bank Rate Repo Rate Reverse Repo Rate Reserve Ratios CRR SLR Lending Deposit Rates Base Rate Rate 6% 8.0% 7.0% 6% 24% 9.25% 10%

Savings Bank Rate Deposit Rate

4% 7.75% 9.10%

IBS | The above case study is a compilation of data extracted from The Business Standard, bankbazaar.com and the internet. This document is meant only for academic purposes in IBS Hyderabad and has been compiled by Ainesh Mukherjee- a student of the college.