Tuesday, April 21, 2009

[Investors Please Listen] RBI Annual Policy Review - token cut signaling priority for growth, softer interest rates

Token cuts for key policy rates; CRR and SLR remain unchanged

In its Annual Policy Review for FY10 today, RBI cut key policy rates (repo and reverse repo) by 25bps each with immediate effect. Repo and reverse repo rates now stand at 4.75% and 3.25%, respectively. CRR and SLR, however, remain unchanged at 5.0% and 24.0%, respectively.

 

In our view, the central bank is close to the end of its rate cut cycle. As of now, a large chunk of the reduction in policy rates (repo and reverse repo) has not been transmitted onwards by banks. Accordingly, we had expected RBI to focus more on quantitative tools like augmenting OMOs, putting cap on reverse repo, or rationalizing prudential norms like provisioning requirements or risk weights rather than adopting a rate action once more in this round of policy. We had expected RBI to preserve these last rounds of rate action for a more appropriate time.

 

After the large cut in policy rates since October 2008 (400bps for repo and 250bps already for reverse repo), the current 25bps cut in the policy rates is unlikely to have any material impact on the overall liquidity condition. However, the current move is more of a signal from the central bank indicating that currently it accords priority to supporting growth and is, thus, committed to a softer interest rate regime. We believe, the likelihood of continued slowdown in the real economy may induce RBI to cut repo and reverse repo rates further by up to 25bps each over the next three months.

 

Growth projections down but resilient; year-end WPI projected at ~4%

RBI has kept its growth forecasts for FY10 at ~6.0% and has implicitly assumed normal monsoon for the year. It has also expressed its assumption of economic activity stabilising to some extent on the back of fast correction in commodity prices along with the stimulus packages introduced since H2FY09.

 

RBI expects the Wholesale Price Index (WPI)-based inflation to be in the negative territory during early FY10. It, however, expects inflation to crawl back into the positive zone in H2FY10, and to ~4.0% by end-March 2010. The central bank mentions that the conduct of monetary policy would continue to condition and contain perception of WPI inflation in the range of 4.0-4.5% so that an inflation rate of ~3.0% becomes the medium-term objective.

 

Policy stance retains flexibility

In today's policy, RBI maintains its stance of prioritising growth and providing adequate liquidity on a continuous basis. With the absence of inflation worries at the moment, the monetary policy can now focus entirely on supporting growth. RBI has, however, kept its options open for reacting to international and domestic developments swiftly and continuously.

 

Large borrowing programme a major challenge

RBI has mentioned that the government borrowings for Centre and states will remain high in FY10 on top of a large borrowing in FY09, reflecting the continued need for fiscal stimulus. Managing this huge borrowing is likely to be a big challenge for RBI.

 

Accordingly, RBI is likely to purchase government securities under open market operations (OMO) for ~INR 800 bn along with MSS unwinding of ~INR 420 bn  during H1FY10, which, by way of monetary impact, is equivalent to CRR reduction of ~3.0%. This should leave adequate resources with banks to expand credit.

 

G-sec yields likely to firm up

Government yields have softened significantly today from ~6.4% to ~6.2% and are likely to remain soft for some time with lower inflation and huge amount of liquidity in the system. However, in the next 3-4 months, we expect yields to start firming up again as (a) policy interest rates have almost reached their bottom, (b) future inflationary expectations likely to resurface from next quarter, and (c) strong likelihood of increase in government borrowings from the current projections.


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