First-Quarter Monetary Policy Review 2011-12

RBI intensifies fight against inflation with 50 bps hike in repo rate July 26, 2011

The Reserve Bank of India (RBI), in its first quarter review of monetary policy 2011-12, continued with its aggressive anti-inflationary stance. It raised the repo rate by a higherthan-expected 50 basis points (bps) to 8.0 per cent. This is the eleventh successive increase in the policy rate since March 2010. Consequently, the reverse repo rate and marginal standing facility (MSF) rate have been revised up to 7.0 and 9.0 per cent, respectively. This rate increase, which came in the midst of slowing industrial growth, is a clear signal from the RBI that it remains committed to inflation control and is willing to accept a slowdown in economic growth in the short run. The central bank has also taken into account the elevated inflationary expectations in food prices, and its resultant effect on wages. In addition, domestic fuel prices have been only partly aligned to global crude oil prices, which have risen sharply over the last one year. However, despite this rate increase, inflation will continue to persist above the RBIs comfort zone throughout 201112. The RBI has revised upwards its March 2012 WPI (Wholesale Price Index) inflation projection to 7 per cent from the earlier projection of 6 per cent with an upward bias. Inflation remains stubbornly above 9 per cent Inflation reached 9.4 per cent in June 2011 as compared to 9.1 per cent in May 2011. Also, inflation for April 2011 has been revised to 9.7 per cent from 8.7 per cent reported earlier. The push in inflation in June came from manufactured goods and food items. Overall, food inflation (primary and manufacturing) in June rose to 8.4 per cent as compared to 8.0 per cent in the previous month. Fuel inflation during the month rose to 12.8 per cent following an increase in petrol and diesel prices. Manufacturing inflation in June remained high, rising to 7.9 per cent from 7.7 per cent in the previous month. Core inflation (non-food manufacturing inflation) in June continued to be firm as well at 7.8 per cent, same as in the previous month, indicating firm demand. If consumption remains robust, an increase in the cost of production due to the fuel price rise will be passed on by producers to consumers thereby further raising manufacturing inflation. In this situation, the RBI will continue with its anti-inflationary stance. In view of the elevated inflationary pressures, CRISIL Research has raised its average WPI inflation forecast for 2011-12 by 50 bps to 8.0-8.5 per cent. GDP growth to moderate as cumulative interest rate hikes begin to impact Industrial growth fell to 5.6 per cent in May 2011 from 8.5 per cent in the same month last year, mainly due to poor performance of the manufacturing and mining sectors. IIP (Index of Industrial Production) data for April 2011 has been revised downward to 5.8 per cent from 6.3 per cent reported earlier. This indicates sluggish industrial growth in the economy. Capital goods also grew by a mere 5.9 per cent in May as compared to 7.3 per cent (revised downward from the earlier estimate of 14.5 per cent) in the previous month. With the capital goods growth slowing to 6.6 per cent in the first two months of 2011-12 compared to 25.6 per cent in the same period last year, investment activity in the economy has clearly slowed down. As a result, capital goods production is expected to remain sluggish in the coming months. However, while private consumption growth has moderated since the third quarter of 2010-11, it remained robust at around 8 per cent in the fourth quarter of 2010-11. Overall, GDP growth would moderate in 2011-12 to 7.7-8.0 per cent, assuming a normal monsoon, compared to 8.5 per cent in 2010-11. It is critical that demand side pressures are reigned in to control core inflation. Liquidity deficit begins to ease While banking sector liquidity continues to be in deficit, the liquidity situation improved in July 2011 as net repo transactions under the Liquidity Adjustment Facility window fell to an average of Rs 332 billion, almost half the amount as compared to the previous month. Drawdown of government cash balances with the RBI and improved deposit growth following increase in the deposit rates by commercial banks helped improve the liquidity situation in July. As a result, the call rate remained largely stable at around the repo rate. Liquidity, though, is expected to remain in the deficit in the coming months due to the governments substantial borrowing programme. As per the borrowing scheduled for JulySeptember 2011, the government plans to raise about Rs 130 billion from the market.

Chart 1: RBI continues to raise rates

9 8
Repo Call rate % MSF %

9 8 7

7 6 5
Reverse repo

6 5

12 -May-11

17 -May-11

22 -May-11

27 -May-11

21 -Ju n-11

26 -Ju n-11

11-Jun- 11

2-Ma y- 11

7-Ma y- 11

16 -Ju l-11
Feb-11

21 -Ju l-11
Apr-11
Feb-11 Jul-11

Source: RBI, CCIL Chart 2: WPI inflation remains high

y-o-y%

Overall WPI

Total Food

Nonfood mfing

25 20 15 10 5 0 -5 -10

Oct-09

Dec-09

Oct-10

Dec-10

Jun-09

Jun-10

Feb-09

Feb-10

Aug-09

Source: Ministry of Industry, CRISIL Research Chart 3: Industrial growth moderates

%
20 15 10 5 0 -5 -10 IIP-General 3-months Moving average

Aug-09

Aug-10

Aug-10

Nov-09

May-09

May-10

Nov-10

Jun-11
10 9 8 7 6 5 4 3 2 1 0

Apr-09

Apr-10

Source: CSO Chart 4: Liquidity remains stretched

Net LAF transactions, Rs bn (LHS) Call Rates (%) 2000 1500 1000 500 0 -500 -1000 -1500 -2000

Mar-10

Nov-09

Nov-10

May-10

Mar-11

Jul-09

Jan-10

Jul-10

Jan-11

Source: RBI, CCIL

May-11

Sep-09

Sep-10

May-11

Feb-09

Feb-10

26 -Ju l-11

11-Jul-11

1-Jun -11

1-Jul -11

6-Jul -11

Impact on the Banking Sector

Deposit growth to be robust at 18 per cent by March 2012 Due to deficit liquidity conditions and persistent demand for credit, a number of banks increased deposit rates by 50-70 bps in the first quarter of 2011-12. As real returns turned positive, depositors preferred to channelise their savings towards bank deposits. Consequently, deposit growth improved to 18.5 per cent as on July 1, 2011 from 17.6 per cent as on April 8, 2011. Several banks have repaid institutional deposits which were raised towards the end of March 2011 to meet annual targets. With the RBI adopting an aggressive anti-inflationary stance, CRISIL Research expects further increases in the deposit rates across maturities over the next two quarters. Thus, with the increase in deposit rates and real interest rates becoming more attractive, deposit growth is expected to be in the range of 18 per cent by March 2012. Credit growth to moderate to around 18 per cent by March 2012 Aggregate y-o-y bank credit growth moderated to 20.1 per cent as on July 1, 2011 from 22.1 per cent as on April 8, 2011 due to the successive increase in policy rates totaling 125 bps so far this fiscal. Rising interest rates have led to a slowdown in credit growth for sectors such as infrastructure, food processing and petrochemicals. CRISIL Research expects credit growth to slow down further to around 18 per cent by March 2012 due to a deceleration in capital investments across sectors. With the repo rate being the effective policy rate, the 50 bps increase would push up the cost of funds for banks. However, slowing credit demand and limited ability of banks to pass on the increase in cost of funds would lead to a 15-20 bps decline in the net interest margins of banks in 2011-12. Incremental credit-deposit ratio to be at 75-80 per cent by March 2012 With moderation in credit offtake due to higher interest rates, and relatively higher growth in deposits, the incremental credit-deposit ratio declined to 79.9 per cent on July 1, 2011 from 90 per cent on April 8, 2011. As this scenario is likely to continue, CRISIL Research expects the ratio to stabilise at 75-80 per cent by the end of 2011-12. Table 1: Macroeconomic forecast 2011-12 Parameter Growth (%) Agriculture Industry Services Total GDP Inflation Interest Rate Exchange Rate Fiscal deficit
Source: CRISIL Research
120% 100% 80% 60% 40% 20% 0%

Chart 5: Growth in credit and deposits

30% 25% 20% 15% 10% 5% 0%
Deposit growth Credit growth

Mar-10

Dec-09

Dec-10

Mar-11
Apr-11 Feb-11
24.4 33.7 24.7 37.0 29.9 23.2 21.3 23.9 26.2 26.5 28.2 28.0 28.0

Sep-09

Sep-10

Jun-09

Jun-10

Source: RBI, CRISIL Research Chart 6: CD and incremental CD ratios

Credit-deposit ratio Incremental credit-deposit ratio

Dec-09

Dec-10

Oct-09

Jun-09

Jun-10

Oct-10

Apr-10

Aug-09

Feb-10

CD: Credit-deposit Source: RBI, CRISIL Research Table 2: Sector-wise bank credit growth
(Grow th, Industry Services Persona Textiles y-o-y %) l loans 1QFY09 2QFY09 3QFY09 4QFY09 1QFY10 2QFY10 3QFY10 4QFY10 1QFY11 2QFY11 3QFY11 4QFY11 May 2011 26.9 30.6 30.2 25.8 21.2 17.9 15.7 20.1 25.8 29.2 27.4 23.6 26.7 31.3 35.3 27.6 19.2 20.5 11.0 11.5 15.0 14.1 21.0 25.0 23.9 21.8 15.9 17.4 14.6 8.5 5.5 2.3 -0.4 4.7 6.5 8.9 13.4 17.0 17.7 20.9 23.1 18.4 12.5 8.3 9.3 9.2 12.7 18.6 16.7 17.0 19.2 20.7 Iron & Infrastruc iron ture products 41.7 35.8 38.5 35.1 35.1 44.7 43.2 42.3 44.3 55.0 43.1 38.6 38.7

2.7 7.3 9.4 7.7-8.0 8.0-8.5 8.1-8.3 43.0-44.0 5.0

WPI Average 10-year G-sec (Year-end) Re/US$ (Year-end) Fiscal Deficit (as a % of GDP)

FY: Financial year

Source: RBI, CRISIL Research

Aug-10

Jun-11

Jun-11

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