Sucheta Dalal :RBI outlines a calibrated exit strategy
Sucheta Dalal

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RBI outlines a calibrated exit strategy  

April 20, 2010

Anchoring inflation expectations without straddling the recovery process seems to be the prime focus of the Reserve Bank of India (RBI). In a move that was largely in line with market expectations, the central bank hiked policy rates and cash reserve ratio (CRR) by 25 basis points (bps), while leaving the bank rate unchanged, in its annual policy for FY11.

With this move, short-term lending and borrowing rates (repo and reverse-repo) between RBI and banks stand at 5.25% and 3.75% respectively, while the CRR would be at 6%. The hike in CRR is expected to absorb about Rs12,500 crore of excess liquidity from the system.

Chanda Kochhar, managing director and chief executive officer, ICICI Bank, said, "The 25 bps increases in the repo and reverse repo rates and the CRR are broadly in line with market expectations given the strong economic growth and elevated level of inflation. At the same time, the RBI has also articulated as a priority the availability of credit to meet the growth needs of the Indian economy. Thus, the annual policy statement has balanced the twin objectives of growth and price stability.”

"The RBI appears comfortable on sustained growth given the uptrend in exports, broad-based industrial recovery, uptick in services and improved corporate profitability. This, coupled with the increase in flow of funds to the commercial sector, is key to its view that the domestic balance of risks shifts from growth slowdown to inflation,” said Rohini Malkani, economist, Citi India.

Echoing the same, Yashika Singh, head for economic analysis, Dun & Bradstreet India, said, “An increase of 25 bps across key policy rates indicates a complete shift in the focus of the monetary policy towards the containment of inflationary expectations. At a time when economic growth is showing signs of consolidation, and demand-side pressures are expected to start building up slowly, this rate hike will put the monetary policy ahead of the curve. Even though we had initially believed that the rate hike might not occur at this juncture, the central bank has accorded a high priority towards rising inflation when it comes to downside risks to growth.”

However, with this moderate stance, there is a concern that the RBI may be behind the curve in curbing inflation. The wholesale price index-based inflation is hovering around the 10% mark, while food inflation is again inching upwards, nearing 18%.

Wholesale price-based inflation remained below the psychological two-digit score, inching up marginally to 9.9% in March from 9.89% in the previous month. The hike was because of rising prices of sugar and pulses. There are many who believe that the RBI is going soft on taming inflation.

Aneesh Srivastava, chief investment officer, IDBI Fortis Life Insurance Co Ltd said, “RBI’s monetary policy has to be read in conjunction with the 10% inflation (WPI), a 16.5% growth in M3, a 15%-17% growth in IIP, high capacity utilisation, a 7% plus current and 8.5% expected growth in GDP and rising asset prices. Hence, it had become necessary for the RBI to exit from emergency monetary measures adopted to support growth and lean towards controlling inflation and inflationary expectations, thus moving towards a more neutral interest rate environment. This current move is one step closer towards tightening the monetary policy in the months to come.”

He added, “Inflation may take longer to start coming down due to poor monetary policy transmission to credit markets. We expect inflationary pressures to subside during the second half of this fiscal year due to policy action and base effect but the future course of inflation would also depend upon (the) quality of (the) monsoon.”

Navneet Munot, chief investment officer, SBI Mutual Fund, believes that the rate hike is a kind of middle-path chosen by the RBI. “RBI has done a terrific job in managing the crisis; but managing the recovery in the backdrop of these conflicting objectives could be more challenging. A 25-bps hike in policy rates and CRR is a middle-path chosen by the RBI and we believe another 25-bps hike in policy rates before the July policy is highly likely,” Mr Munot added.

Economists too believe that another rate hike is on the cards, as inflationary pressures will need to be eased further.

Indranil Sen Gupta, chief economist-India, Bank of America Merrill Lynch observed, “We expect an additional 100-bps rate and 50-bps CRR hike through FY11 to combat inflation. In our view, recovery is strong enough for the RBI to move against inflation as it expectedly has. The move is also towards normalisation of monetary policy to promote healthy growth.”

"With the RBI stating that ‘despite the 25 bps hike, our real rates are still negative, and with the recovery now firmly in place, we need to move in a calibrated manner in the direction of normalising our policy instruments’, we maintain our view of a minimum additional 75-bps hike in 2010, with a possibility of an inter-policy hike before its 27th July meeting,” said Ms Malkani.

Although the central bank has deployed tools for inflation control assuming a normal monsoon, any change in the pattern of rainfall may create further dilemmas for policymakers.

“There will be an upward pressure on interest rates, but it is unlikely to impact credit growth immediately. Going forward, we expect a further increase in CRR during May-June, given that the upward pressures on liquidity are likely to persist on account of expected sustained foreign fund inflows. Moreover, the tools deployed towards inflation control and the maintenance of current growth momentum are underscored by an assumption of a normal monsoon—any deviation in the monsoon is likely to create further dilemma on the policy front,” added Ms Singh.

With the expected pickup in demand from the private sector, the RBI has said that managing government borrowings will be a bigger challenge than last year and would warrant a fine balancing act. While the overall gross borrowing requirement for FY11 is lower than last year, given the absence of Market Stabilisation Scheme (MSS) and Open Market Operations (OMO), the fresh issuance of securities in FY11 is expected to be 36.3% higher than FY10.

“The large government borrowing in H1 FY11 would put pressure on long-term interest rates and may be challenging due to high inflation, strong recovery in growth, lower liquidity and private credit demand,” said Alok Sahoo, head of fixed income, Baroda Pioneer AMC. — Moneylife Digital Team

-- Sucheta Dalal