May 4, 2011

MONETARY POLICY REVIEW 2011 - 2012

After following a calibrated tightening policy for the last one year, the Reserve Bank of India (RBI) took an aggressive step in the latest Annual Monetary Policy of FY11-12. The Central bank sent out a clear antiinflationary stance by hiking the repo and reverse repo rate by 50 bps to 7.25% and 6.25% respectively. Cash reserve ratio remained unchanged at 6% level. Further, in an attempt to reduce the spread between the savings deposit and term deposit rates, RBI decided to increase the savings bank deposit interest rate from the present 3.5% to 4.0% with immediate effect. The hike has come in an environment of macroeconomic
constraints due to higher international commodity and fuel prices coupled with the mounting domestic nonfuel price index. The visible signs of monetary actions are reflected in moderation of growth, particularly in capital goods production and investment spending.

Further, the RBI expects inflation to remain elevated in the first half of the fiscal year before easing in the second half and set a target of 6% headline inflation, with an upward bias, for FY2012. High prices of oil and other commodities and the cumulative impact of monetary policy measures is expected to moderate
growth to about 8% in FY2012, assuming a normal summer monsoon and global crude oil prices of $110 a barrel.

Apart from the aggressive policy stance, RBI came out with some changes in the operating procedure of monetary policy. The changes are based on the group recommendations made in July 2010.

  • The weighted average overnight call money rate will be the operating target of monetary policy of the Reserve Bank.
  • In the monetary policy RBI would henceforth would have only one independent policy rate i.e., Repo rate. This is expected to more accurately signal the monetary policy stance. The spread between repo and reverse repo would be fixed at 100 basis points.
  • RBI will start new Marginal Standing Facility (MSF) wherein banks can borrow overnight from the MSF up to 1% of their respective net demand and time liabilities or Net Demand and Time Liabilities (NDTL). The rate applicable would be 100 basis points above the repo rate. MSF will come into force from 7th May 2011.
Impact analysis

Increase in repo and reverse repo rates has an impact on both borrowing and lending costs. Ideally, it should result in an increase in both deposit and lending rates. In recent times lending rates have not kept pace with the upward trajectory of repo rates. Ideally a hike in base rate is expected to have an effect on their net interest margin (NIM). It remains to be seen if bankers will toe the line of the Reserve bank on the basis of the latest policy initiatives. If bankers indeed chose to pass on this rate hike, it will mean dearer loans and higher EMIs/tenor, thus negatively affecting rate sensitive sectors like auto and infrastructure.

For depositors, a higher deposit interest rate is good news. The banks might like to think otherwise as the latest move could increase the cost of deposits and their net interest margin could be negatively impacted.

Overall the bond market was expecting a minimum of 25 basis points of hike and this negative surprise would be reflected in the upward movement of bond yields. The yield on benchmark paper has moved up around 9 basis points against last Friday close. The marginal standing facility announced by RBI shows its support for the banks in case of tightening liquidity scenario going further.

--By ICICI Prudential Mutual Fund

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