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INDIA ECONOMICS: EXPECTATIONS FROM RBI’S MID-TERM MONETARY POLICY REVIEW ON NOVEMBER 2, 2010
We expect RBI to effect the last round of policy rate hike of 25 bps in Repo and Reverse Repo rate despite tight liquidity situation. The hardening of inflationary expectations and inflation settling in high single digit would be the trigger points for this action while RBI considers the liquidity stress ‘frictional’ and would change course to MORE accommodative stance for remaining FY11.
THE BACKDROP
1) Growth and inflation outlook
- September inflation at 8.6% has shown signs of stabilization after remaining in double digit for five consecutive months. All major CPI inflation indicators have come down to single digit level too.
- However, inflation has remained in high single digits and although there is a visibility of decline, inflationary expectations have shot up as per RBI’s inflation expectations survey. The latest (June 2010) survey indicates that households expect inflation to rise further by 30-80 bps during Q2FY11 and in FY12.
- Meanwhile despite the inexplicable fluctuations in IIP figures, growth outlook remains robust with 2Q revenue growth of companies being the highest in six quarters for the companies that have announced results so far.
2) Liquidity situation turns stressful
- The evidence of funding gap manifested itself into uptrend in money market rates (that touched 12% in intraday trading (and averaged 7.7%) on October 29, higher G-sec yields (10-yr hovering between 8.11-8.14% and greater recourse on RBI repo window (close/exceeding Rs1000bn).
- RBI announced some special liquidity announcement measures on October 29 for two days including 1) reintroduction of second LAF and 2) reduction in SLR requirement by 1% for the purpose of additional borrowing from RBI. Most notably these measures were extended on October 31 till November 4, 2010.
3) QE-II looms in the external front
- US FED is widely expected to take additional quantitative easing measure in its meeting later this week.
- This comes on the back of India receiving heavy capital inflow during the two months September-October (US$11.8b in equity).
- The QE-II may facilitate higher capital flow holding promise of further easing of the domestic liquidity situation.
OUR ASSESSMENT AND EXPECTATIONS FROM POLICY
- Money market - hardening may be viewed temporary: Short-term interest rates have firmed up on the back of seasonal liquidity demand acting on top a funding gap.Indeed our liquidity assessment framework predicted highest liquidity stress in Q3FY11. However, the liquidity situation may improve somewhat after the festive season, possibility of higher capital flow on the back of QE-II by US FED and continued liquidity support by RBI. The Nov 1 bids for repo have nearly halved already to Rs 680 b from Rs1,316 b on Oct 29 while call rates and G-sec yields have eased somewhat.
- G-sec market – contrasting evidence: While G-sec yields have expectedly hardened on higher supply, inflation expectations and tight liquidity the market has so far chosen to ignore the cues from moderation in inflationary outlook, slow pick up in credit demand, easing of liquidity on the back of heavy capital inflow and possible impact of QE-II by US FED, consolidation of the fiscal situation, and expected ease in liquidity after the auction of FIIs increased limit for debt investments.
- Liquidity – a relook: Assessment of the above two markets lead us to conclude that RBI may treat the management of liquidity separate from its longer term objective of conclusion of the rate hike cycle. Furthermore, extension of special liquidity measure till November 4, points to RBI treating the liquidity stress situation temporary and would continue with such measures necessary to ease the situation at the margin. Indeed, RBI circular maintains the liquidity hardening as ‘frictional’.
- Inflation – challenge remains and pause does not serve the purpose – While policy rates are already near normal from a cross cyclical point of view as signaled by RBI in its previous policy statement, inflationary outlook remains challenging with inflation hovering in high single digit and inflationary expectations still inching up. In the prevailing circumstances, a pause might create a policy vacuum as far as fighting inflation is concerned while deferment doesn’t serve the purpose as inflation is expected to moderate fairly linearly going forward.
- QE-II: RBI may not have the benefit of hindsight of the US FED policy scheduled to be held on 2-3 Nov. However, there is widespread expectations of FED injecting at least half a trillion dollar into the system. It is evident it would be difficult to effect a policy rate hike later when extraordinary easy conditions would prevail elsewhere. Policy rates would need to be in greater sync in remaining FY11 after FED measure. The time to effect the last round of domestic policy hike thus appears now as rate hikes effected later could bring larger than warranted capital flows. For the remaining part of FY11, we expect RBI to change track to accommodative stance as the continuance of a decoupled monetary policy would accentuate exceess capital flow and eventually undermine domestic monetary policy.
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