monetary policy may 2011

8/6/2019 Monetary Policy May 2011

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The Annual Policy Review, 2011-12

Contents

Sections

Highlights of the Policy 1

Overview 2

I. High inflation to persist in 2011-12 3

II. India’s growth to moderate in 2011-12 5

III. Global economy recovers, but downside risks persist 6

IV. Impact analysis on the economy 7

V. Impact analysis on banking sector 8

Outlook

GDP growth: Growth is expected to moderate between 7.7-

8.0 per cent in 2011-12 due to higher interest rates and impact

of past rate hikes impinging on industrial and service sector

growth. Some moderation in agricultural growth due to a higher

base of last fiscal is already built in the forecast.

Inflation: Inflation in 2011-12 will remain high and outside

RBI’s comfort zone reflecting strong persistence. Upside risks

from higher commodity, food and metals prices as well as

rising core inflation would keep average inflation in 2011-12

around 7.5-8.0 per cent.

Interest rates: We expect yield on the10-year G-sec to end

2011-12 in the range of 8.1-8.3 per cent. Our forecast takes

into account both the improved liquidity situation and an

upward revision.

Exchange rate: Rupee is expected to continue to appreciate

in 2011-12, albeit at a moderate pace. We expect the rupee to

settle in the range of Rs 43.0-44.0 per dollar by March 2012.

Deposits: Aggregate deposits to grow at 17-18 per cent in

2011-12

Advances: Aggregate credit to grow at around 18 per cent in2011-12.

Monetary policyIMPACT ANALYSIS

May 2011



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CRISIL RESEARCH MONETARY POLICY IMPACT ANALYSIS, MAY 2011 1

The Annual Policy Review 2011-12

Highlights of the Policy

• Repo rate to be the single operating policy rate. A 200 basis points (bps) corridor around the repo rate to set

the ceiling and the floor for interbank short-term rates.

• Reverse repo fixed at 100 bps below the repo rate.

• Marginal Standing Facility (MSF) rate through which banks can borrow up to one per cent of their net

demand and time liabilities (NDTL) using SLR securities fixed at 100 bps above the repo rate.

• The weighted average call money rate to be the operating target of monetary policy.

• Repo rate under the liquidity adjustment facility (LAF) increased by 50 bps to 7.25 per cent.

• The cash reserve ratio (CRR) unchanged at 6 per cent of NDTL of scheduled banks.

• Savings bank deposit interest rate increased to 4.0 per cent from 3.5 per cent.

• The RBI projects real gross domestic product (GDP) growth in the range of 7.4 to 8.5 per cent for 2011-12

with the assumption of a normal monsoon and crude oil prices averaging $110 a barrel.

• The RBI projects the wholesale price index (WPI) inflation for end-March 2012 at 6.0 per cent with an

upward bias.

• Money supply growth is projected at 16.0 per cent in 2011-12 while growth in non-food credit and aggregate

deposits to be at 19.0 and 17.0 per cent, respectively.

• To extend the period of short sale in the central government securities from the existing 5 days to a maximum

period of 3 months.

• To allow FIIs to cancel and rebook up to 10 per cent of the market value of the portfolio as at the beginning

of the financial year.

• A committee to be appointed to re-examine the existing classification and suggest revised guidelines with

regard to priority sector lending classification.

• At least 25 per cent of new bank branches opened during a year to be in unbanked rural centres.

• To permit Urban Cooperative Banks (UCBs) to lend to self-help groups (SHGs) and to keep lending to SHGs

out of the norm on unsecured advances.

• To permit well-managed and financially sound UCBs to become members of the negotiated dealing system

(NDS).

• To allow UCBs to utilise the additional 5 per cent of their total assets permitted earlier for housing loans up

to Rs 15 lakh.



2 CRISIL RESEARCH MONETARY POLICY IMPACT ANALYSIS, MAY 2011

Overview

War on Inflation

The ongoing phase of inflation can be easily classified as one of the most stubborn episodes in the last 2 decades.

All through 2010-11, inflation persistently defied expectations of the central bank as well as market participants

because of the continual change in its drivers. Taking cognizance of this, RBI went in for a steeper hike of 50

basis points in its Annual Policy Review. In addition to the monetary policy action, the market also keenly awaits

the Annual Policy for its guidance on growth and inflation. The RBI’s GDP growth expectation of 8.0 per cent

for 2011-12 looks feasible. The March 2012 inflation target of 6 per cent too is achievable as we believe that

inflation could peak out by the second half of 2011-12 when impact of monetary tightening on core inflation

begins to take hold. The yields on 10-year G-Secs are expected to settle at 8.1-8.3 per cent by the end of 2011-12.

Inflation has remained elevated despite a cumulative repo rate hike of 200 basis points by the RBI (upto March-

end 2011) after it reversed its easy monetary stance in March 2010. In March 2011, WPI-based inflation stood at 9

per cent as against the initial projection of 5.5 per cent by the RBI in April 2010, which was maintained till

December 2010. While supply driven inflation, cannot be effectively controlled via the monetary policy, the

transmission of surging food and commodity prices to other sectors of the economy has risen in recent months and

warrants tight monetary policy. This uptrend in core inflation (measured as non-food manufacturing inflation)

signals the emergence of demand pressures on inflation. Rising wages and commodity prices too are exerting

pressure on cost of production and prices. The stubbornness of inflation can be gauged from the fact that despite

these steps RBI hopes to bring down inflation to around 6 per cent by March 2012, which is still above RBI’s

comfort zone.

After registering a strong show in 2010-11, the economy has started to show some signs of fatigue. Investment

growth too has slowed, although private consumption remains strong. The growth moderating impact of past rate

hikes will continue to play out through the current fiscal. Accordingly, growth in private consumption demand

will moderate in 2011-12. CRISIL expects GDP growth to slow down to 7.7-8 per cent in 2011-12 from 8.6 per

cent in 2010-11. This should gradually curb demand pressures on inflation and limit the transmission of high input

costs into final products. We expect average WPI based inflation at 7.5-8 per cent range in 2011-12.

Some important reforms initiated by RBI include raising the savings deposit rate by 50 basis points to 4 per cent

as a first step towards de-regulating it. It also made the repo rate the single operating policy rate in accordance

with the recommendations of Mohanty Committee report. There is also some progress on launching of plain

vanilla credit default swaps (CDS). All these are important steps towards improving the transmission and hence

the effectiveness of monetary policy actions. Last but not the least the fiscal deficit should be kept under control

to complement RBI’s demand moderating actions.

Dharmakirti JoshiChief Economist, CRISIL




I. High inflation to persist in 2011-12

• Although successive interest rate hikes by the RBI since March 2010 have moderated demand side pressure,

especially investment growth to an extent, further reining in of demand pressures will be inevitable

consequences of an on-going monetary tightening. Despite demand pressures moderating, inflation is

expected to remain high throughout 2011-12. Accordingly, we have revised our inflation forecast upwards for

2011-12 and expect average WPI-based inflation to be in the range of 7.5-8.0 per cent from earlier forecast of

5.8-6.0 per cent. The upward revision is mainly attributed to increase in our annual forecast of crude oil

prices along with sharper-than-expected rise in non-food manufacturing inflation.

• WPI-based inflation averaged 9.4 per cent in 2010-11 compared to 3.6 per cent in the previous year. March-

end 2011 inflation stood at nearly 9.0 per cent as against the RBI’s initial projection of 5.5 per cent in April

2010, which was maintained till December 2010. Inflation in the first half of 2010 was mainly driven by food

prices (both primary and manufacturing). However, towards the fourth quarter of 2010-11, core inflation

(non-food manufacturing), which indicates demand-side pressures in the economy, began accelerating. The

pass through of input costs, in terms of fuel and other raw material costs, into the final output prices suggest

relatively robust demand conditions in 2010-11. The sharp increase in non-food manufacturing inflation in

recent months is of particular concern to the central bank, as it indicates spillover of supply shocks to

generalised inflation through input cost channel and inflation expectations.

• Inflation and inflationary expectations continue to remain elevated. A good indicator of the buildup of

inflationary pressure is the quarter-on-quarter seasonally adjusted inflation rate. Inflation momentum,reflected by this indicator rose to 9.6 per cent during the fourth quarter of 2010-11. This suggests that

inflation would continue to remain firm and significantly above the RBI’s comfort zone of 5.0 to 5.5 per cent

throughout 2011-12. In this scenario, the increase in key policy rates announced in the 2011-12 annual policy

was as per expectations.

Figure 1: Inflation not coming down as expected Table 2: Inflationary pressure in the non-food

manufacturing sector builds up

-10.0

-5.0

0.0

5.0

10.0

15.0

Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11

Manufacturing inflation, ex-food (seasonally adjusted q-o-q annualised)

WPI inflation

0.0

5.0

10.0

2006-07 to

2008-09 Q2

2008-09 Q3 to

2009-10 Q2

2009 -10 Q3 to

2010-11Q3

2010-11Q4

Upturn Crisis Recovery

M anu excl food_SA Repo rate

y-o -y%

Source: Ministry of Industry, CRISIL computations Source: Ministry of Industry, CRISIL computations




• To improve policy transmission from policy interest rates to the short-term inter-bank rate (call rate) and to

curtail volatility of call rates, the RBI has announced changes to its monetary policy operating procedure.

Henceforth, the repo rate would be the single policy rate with a fixed 200 basis points corridor around it.

Reverse repo rate would be 100 basis points lower than the repo rate and the rate under marginal standing

facility (MSF) will be 100 basis points above the repo rate. Under the MSF, commercial banks can borrow up

to 1 per cent of their NDTL using the government securities from the SLR portfolio without inviting penalty.

• Liquidity tightened since June 2010 owing to high inflation and increase in currency with public. In addition,

from the second quarter of 2010-11, rising demand for credit from the corporate sector drove up lending

rates. While higher retail interest rates were warranted, the RBI had to undertake liquidity easing measures so

as not to disrupt the money market operations. Recently, the RBI announced the extension of liquidity easing

measures to May 6, 2011 that were due to expire on April 8.

• The RBI is expected to continue with its liquidity management operations by maintaining liquidity at a

reasonable deficit level in order to strengthen transmission of policy rate hikes to short term inter-bank rates.

This would be necessary to improve the pass through of policy rates to retail interest rates and therefore

demand, so as to rein in inflation and inflationary expectations.

Figure 3: Liquidity situation

(2,100.0)

(1,500.0)

(900.0)

(300.0)

300.0

900.0

1,500.0

2,100.0

Apr-10 Jun-10 Aug-10 Nov-10 Jan-11 Apr-11

0.0

2.0

4.0

6.0

8.0

10.0

%

Net LAF transactions, Rs bn (LHS) Call rates Repo rate Reverse repo rate

Source: RBI




II. India’s growth to moderate in 2011-12 with deceleration in industrial and service sector growth

• In 2011-12, growth is expected to moderate amidst elevated inflation pressures and rising interest rates. The

impact of past monetary actions and reduction in pricing power as demand moderates, will slow down

industry and services growth. The services sector will remain strong; however, is expected to be lower at 9.4

per cent, while industrial growth will decelerate to 7.3 per cent. Agriculture growth, despite a normal

monsoon, will decline to 2.7 per cent given a higher base. Consequently, overall growth is expected to be in

the range of 7.7 to 8.0 per cent.

• In 2010-11, rising demand-side inflation pressures prompted the RBI to take aggressive but prudent

tightening measures. Although private consumption boosted domestic demand, higher interest rates started

impacting investment demand towards the second half of the year. Divergent trends were also observed in private consumption and investment, which generally move in tandem.

• We expect investment demand to continue to moderate, while private consumption demand too could start

slowing down. With the announced hike of 50 basis points (bps), the cumulative increase in repo rate till date

(March 2010 to May 2011) is of 250 bps. Assuming a further increase in interest rates in 2011-12, slowdown

in consumption and investment activity is evident.

Figure 4: Economic growth vs inflation Figure 5: Investment slowdown, robust consumption

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Q1 Q 2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q 3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

FY07 FY08 FY09 FY10 FY11

Inflat ion GDP

y-o -y%

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Mar-

08

Jun-

08

Sep-

08

Dec-

08

Mar-

09

Jun-

09

Sep-

09

Dec-

09

Mar-

10

Jun-

10

Sep-

10

Dec-

10

Pr ivate consump tion Fixed investment

y-o -y%

Note: Fourth quarter of 2010-11 GDP is estimated

Source: Government of India, RBI, CRISIL computations

Source: CRISIL Estimates




IV. Impact analysis on the economy

• GDP growth – GDP grew at an estimated 8.6 per cent in 2010-11 after recording 2 consecutive years of

growth, which was below its recent trend. This was largely driven by the buoyant agricultural growth,

supplemented with strong performance of service sector. Going forward, GDP growth is expected to

moderate and settle in a range of 7.7 to 8.0 per cent in 2011-12 due to higher inflation pressures and rising

interest rates pulling down consumption and investment demand. Impact of past rate hikes, reduction in

pricing power and the direct and indirect impact of elevated crude prices pose downside risks to overall

growth. Agriculture growth, in spite of a normal monsoon, would decline given a higher base.

• Inflation – Headline inflation exhibited strong persistence in 2010-11 due to supply-side shocks and gradual

generalisation of price pressures. Inflation path remains sticky and risks are on upside despite the current

anti-inflationary stance of the RBI. Going forward, headline inflation is expected to remain elevated and

moderate only towards the second-half of 2011-12. High commodity prices especially crude oil prices pose

significant upside risks to inflation in the near-term. On average, we expect WPI-based inflation to average in

the range of 7.5-8.0 per cent in 2011-12.

• Interest rate – Interest rates stayed firm during the second half of 2010-11, to close the year at 8.0 per

cent. Concerns over inflationary expectations and liquidity situation falling in deficit mode for most of the

year led to hardening of yield across maturitie short end and long end. For 2011-12, while liquidity situation

is expected to see a marked improvement following the RBI’s liquidity easing measures and rising capital

inflows, inflationary flames continue to stay rampant. Overall, on balance, we expect yields on the benchmark 10-year G-Sec to end 2011-12 at 8.1-8.3 per cent

• Exchange rate – Capital flows are expected to remain robust in 2011-12 led by softer monetary policies

and slower economic recovery in the West vis-à-vis India. However, pace of appreciation would remain

uneven and a bit lower than what was witnessed during 2010-11. Therefore, we expect the rupee to stabilise

in the range of Rs 43.0-44.0 per dollar by March 2012.

Table 2: Macroeconomic Outlook

Parameter 2010-11 2011-12

Growth (%) Agriculture 5.4 2.7

Industry 8.1 7.3

Services 9.6 9.4

Total GDP 8.6 7.7-8.0

Inflation WPI Average 9.4 7.5-8.0

Interest Rate 10-year G-sec (Year-end) 8.0 8.1-8.3

Exchange Rate Re/US$ (Year-end) 44.7 43.0-44.0

Fiscal deficit Fiscal Deficit (as a % of GDP) 5.1 5.0 Source: CRISIL Research




V. Impact analysis on banking sector

Deposit growth expected to post a robust 17-18 per cent in 2011-12

Given the tight liquidity conditions and demand for credit, many banks hiked deposit rates by 100-200 bps over the last 3 quarters. During the last quarter of 2010-11, effective transmission of monetary policy was reflected in

higher deposit and higher lending rates of banks. Consequently, deposit growth rate increased to 17.6 per cent as

on April 8, 2011 from 16.6 per cent as on December 31, 2010. The growth, however, was still not enough to meet

the credit demand, resulting in increased issuances of Certificate of Deposits (CDs) during the period.

CRISIL Research expects further rate hikes in deposit rates across maturities in the second half of 2011-12 due to

deposit growth continuing to lag credit growth. With increase in deposit rates and real interest rates turning

positive, deposit growth is expected to be in the range of 17-18 per cent by March 2012.

Credit growth expected to moderate around 18 per cent in 2011-12In the current scenario, with repo rate being the effective policy rate, the increase of 50 basis points is expected to

be transmitted to the banking industry in the form of higher cost of funds. Higher interests on term deposits and

hike of 50 bps in savings deposit rate coupled with a limited ability to pass on the increase in cost of funds is

expected to exert pressure on net interest margins by 20-30 bps.

Aggregate y-o-y bank credit growth moderated to 22.1 per cent as on April 8, 2011 from 24.6 per cent as on

December 31, 2010 owing to hike in policy rates. CRISIL Research expects credit growth to slow down to around

18 per cent in 2011-12 given decelerating capital investments across sectors like telecom, airport infrastructure,

cement and high interest rates impacting the retail segment.

Incremental credit-deposit ratio to be 75-80 per cent by March 2012

CRISIL Research expects incremental credit-deposit ratio to reach around 75-80 per cent by the end of 2011-12,

primarily on account of expected moderation in credit growth in response to higher interest rates and higher

deposit growth rate. This ratio declined to 90.0 per cent on April 8, 2011 from 105 per cent on December 31, 2010

due to moderation in credit offtake and relatively higher growth in deposits.

Figure 7: Growth in credit and deposits Figure 8: CD and Incremental CD ratios

0%

5%

10%

15%

20%

25%

30%

May-

09

Jul-

09

Sep-

09

Nov-

09

Jan-

10

Mar-

10

May-

10

Jul-

10

Sep-

10

Nov-

10

Jan-

11

Mar-

11

Deposit growth Credit growth

0%

20%

40%

60%

80%

100%

120%

M ay-

09

Jul-

09

Sep-

09

Nov-

09

Jan-

10

Mar-

10

M ay-

10

Jul-

10

Sep-

10

Nov-

10

Jan-

11

Mar-

11

Credit -deposit rat io Incremental cred it -deposi t rat io

Source: RBI, CRISIL Research Source: RBI, CRISIL Research




Other key developments

• The RBI has broadly accepted the recommendations of the Malegam Committee in respect of functioning of

microfinance institutions (MFIs). In this, bank loans to MFIs will be eligible for priority sector status only if a

prescribed percentage of their total assets are in the nature of ‘qualifying assets’. Qualifying assets are

required to satisfy the following conditions:

i) Loan disbursed by an MFI to a borrower with a rural household annul income not exceeding Rs

60,000 or urban and semi-urban household income not exceeding Rs 1,20,000

ii) Loan amount not to exceed Rs 35,000 in the first cycle and Rs 50,000 in subsequent cycles

iii) Tenure of loan not to be less than 24 months for loan amount in excess of Rs 15,000 without

prepayment penalty

iv) Loan to be extended without collateral

v) Aggregate amount of loan, given for income generation, not to be less than 75 per cent of the

total loans given to MFIs

vi) Loans to be repayable by weekly, fortnightly or monthly installments at the choice of the

borrower

vii) Banks should ensure a margin cap of 12 per cent and an interest cap of 26 per cent

These moves will enhance regulatory controls over the functioning of MFIs. However, CRISIL Research believes

the clarity in respect of regulations is positive for long-term sustainability of MFIs.

• The RBI has also proposed to appoint a committee to re-examine the existing classification and suggest

revised guidelines regarding priority sector lending classification.

• After doing away with 70 per cent provision coverage ratio (PCR), the RBI has recommended enhancing the

provisioning requirements on non-performing advances by 5-10 percentage points and 2 per cent

provisioning for restructured advances.

i) 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 total of 25 per cent as against the existing 20 per cent)

ii) The secured portion of advances which have remained in ‘doubtful’ category up to one year will

attract a provision of 25 per cent (as against the existing 20 per cent)

iii) The secured portion of advances which have remained in ‘doubtful’ category for more than one

year but up to 3 years will attract a provision of 40 per cent (as against the existing 30 per cent)

iv) Restructured accounts classified as standard advances will attract a provision of 2 per cent in the

first 2 years from the date of restructuring

v) Restructured accounts classified as non-performing advances, when upgraded to standard

category will attract a provision of 2 per cent in the first year from the date of upgradation (as

against existing provision of 0.25-1.00 per cent, depending upon the category of advances).




Table 3: NPA provisioning norms

Secured Unsecured

Earlier Revised Earlier Revised

Sub-standard 10% 15% 20% 25%

Doubtful (up to 1 yr) 20% 25% 100% 100%

Doubtful (1-3 yrs) 30% 40% 100% 100%

Earlier Revised

Provision requirement on restructured assets 0.25-1.0% 2.00%

Source: RBI

• A working group to examine the introduction of a holding company structure for banks and other financial

entities together with the required legislative and regulatory framework was formed in April 2010. The group

is expected to submit its report by end May 2011.

• The RBI has mandated domestic Scheduled Commercial Banks (SCBs) to allocate at least 25 per cent of the

total number of branches to be opened during the year to unbanked rural (Tier 5 and Tier 6) centres. It was

observed that in the last 2 years, SCBs opened an average of 20 per cent of their new branches in these rural

centres.




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