RBI turns on the heat; raises rates 50 bps :: JP Morgan

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RBI turns on the heat; raises rates 50 bps

RBI hikes policy rates by 50 bps as we had expected and higher than market expectations of 25bps In reaction, short rates rise 15 bps and the yield curve flattens 8-10 bps In departing from its calibrated approach, the RBI cites stubborn core inflation and the risk of inflationary expectations coming unhinged RBI pegs FY12 growth at 8%, stressing that near term growth would need to be sacrificed to quell inflationary pressures and safeguard medium term growth RBI expects inflation to remain elevated in 1HFY12 but expects it to slow to 6% by March 2012 Savings deposit rates hiked 50 bps as a likely step towards deregulation A new marginal standing facility introduced to keep the call rate within 100bps of the repo rate Bank provisioning norms tightened, bank investments into debt mutual funds capped and changes made to lending to micro finance institutions (MFIs) RBI changes course and hikes policy rates by 50 bps The RBI hiked policy rates by 50 bps (Repo: 7.25 %; Reverse Repo 6.25 %) at its quarterly review as we had expected (see “India: RBI likely to hike by 50 bps on May 3 though 25 bps still not off the table,” MorganMarkets, April 2011) but above market expectations of 25bps. As a consequence, the IY OIS rose15 bps causing the OIS curve and government bond yield curve to flatten by 8-10 bps. We have long argued that more aggressive monetary tightening was warranted to curb the acceleration in headline and core inflation, anchor ever-increasing inflationary expectations and help restore macroeconomic stability (see, “India: watch out for more aggressive monetary tightening as inflation surges further,” MorganMarkets, April 2011) In departing from its calibrated approach to monetary tightening, the RBI cited these very reasons. Specifically, the RBI noted that (i) the trajectory of headline and core inflation over the last few months have overshot even the most pessimistic of projections; (ii) inflationary expectations have increased hardened and risk getting unhinged; and (iii) accelerating inflation in recent months has been driven primarily by surging non-food manufacturing (core) inflation. FY12 growth pegged at 8 % … The growth-inflation trade off has come under much public debate in the run-up to today’s policy review. As we have previously argued (see, “India: heading for an accidental soft landing,” MorganMarkets, March 2011) growth would have to temporarily slow to help moderate inflation given that any supply response would take time. Additionally, bringing inflation down and restoring macroeconomic stability, is a critical pre-requisite to jump-starting the investment cycle. Today’s RBI’s policy statement addressed this issue head on and reached the same conclusions. It acknowledged that “high inflation is inimical to sustained growth as it harms investment by creating uncertainty” and that the current elevated rates of inflation pose significant risks to future growth. As such, it acknowledged that compromising growth in the short-run would help bring inflation down and boost medium term growth. Under the assumptions of a normal monsoon and crude averaging $110 per barrel over FY12, it therefore pegged GDP growth around 8%, a more realistic assumption than the FY12 budget assumption of 9%. This is consistent with our assumptions of growth printing a shade below 8% for FY12 ..and March 2012 inflation pegged at 6% with an upward bias The RBI admitted that inflation is expected to stay elevated in the first half of this fiscal but expected it to gradually moderate to 6 % (with an upward bias) by March 2012, under the baseline assumptions it is operating under (normal monsoon and crude averaging $110 per barrel in FY12) This also presumes that there will be some increase in the administered prices of petroleum products. The RBI repeatedly emphasized that it was important for the fisc to be consolidated this year so to help moderate aggregate demand and thereby contribute to quelling inflationary pressures. We expect inflation to moderate to 7% by March 2012 much will depend on the extent of fiscal consolidation and the pace and quantum of the remaining monetary tightening. Savings bank deposit rates hiked by 50 bps Consistent with expectations, the savings bank deposit interest rate was increased by 50 bps from 3.5 % to 4 % with immediate effect. Savings bank deposits constitute about 22 % of all deposits and remain the only deposit rate that has a fixed, administered rate. Specifically, savings deposit rates have remained unchanged at 3.5 % since March 2003. Presumably, increasing the administered rate is the first step in eventually deregulating the savings bank rate which in turn, would help with the transmission of monetary policy, increasing the attractiveness of savings deposits and potentially allow for more product innovation. Operating Procedure of Monetary Policy Changed Broadly consistent with the recommendations of the RBI’s working committee on the desired operating procedure of monetary policy, the RBI made several changes to the manner in which it will conduct monetary policy. Specifically, the weighted average overnight call money rate will become the operating target of monetary policy. Furthermore, the RBI announced that henceforth the repo rate will be the only independently varying policy rate, to more accurately signal the monetary policy stance. As a consequence, the reverse repo rate will be pegged at a fixed 100 bps below the repo rate. More importantly, the RBI instituted a new Marginal Standing Facility (MSF), wherein banks could access this facility to the tune of 1 % of their net demand and time liabilities (NDTL) at a rate that would be fixed 100 bps above the repo rate (MSF rate). In essence, therefore, the revised corridor will have a fixed width of 200 bps, with the repo rate at the center of the corridor. Creating a MSF facility is meant to ensure that the call money rate (the operational target) is, for the most part, bounded at the upper end by the MSF rate (i.e. 100 bps above the repo rate). Provisioning tightened; investment in mutual funds capped; and lending to micro-finance regulated The RBI also announced a slew of other regulatory and developmental policies. Broadly accepting the recommendations of the Malegam Committee Report on regulating micro finance institutions. This would entail bank loans to all MFIs being eligible for classification as priority sector if, and only if, they conform to the regulations formulated by the RBI Asking banks to ensure that at least 25 percent of the new branches opened this year are located in tier 5 and tier 6 cities to help promote financial inclusion and ensure that all villages with a population of over 2000 have some banking access by March 2012 Instituting changes in financial markets, including (i) extending the period of short sale in government securities from 5 days to 3 months; (ii) allowing FIIs to cancel and rebook up to 10 percent of the market value of their portfolios Increasing the provisioning requirements of commercial banks on certain categories of non-performing advances Capping investments by commercial banks in the liquid schemes of debt mutual funds to 10% of their net worth. This is meant to prevent excessive circularity of funds with banks investing in mutual funds and mutual funds, in turn, investing in certificates of deposit (CDs) with banks.