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The Reserve Bank of India acts aggressively,
signals more hikes to come
The Reserve Bank of India (RBI) hiked the repo rate by 50 bp and the reverse repo rate by
50 bp, in line with our expectations, but ahead of Bloomberg consensus expectations. 18 out of
25 economists polled by Bloomberg were expecting a 25 bp hike. The bond market was pricing in
close to a 50-bp hike. After today’s decision, the reverse repo rate moves up to 6.25% and the
repo rate to 7.25%. The cash reserve ratio (CRR) remains at 6.00%.
The RBI forecasts inflation at 6% by March 2012 and GDP growth at 8% for FY12. With
regards to the trajectory, inflation is expected to remain at an elevated level in the first half of
FY12, before gradually moderating in the second half. The RBI thought that all the risks to
inflation currently are to the upside. The RBI’s baseline projection for real GDP growth for FY12
is 8%. These forecasts are in line with our own forecasts of 7.8% for GDP growth and 7.5%
average WPI inflation for FY12.
The RBI also increased the administered savings rate of banks by 50 bp, increasing them to
4% from 3.5% earlier with immediate effect. This is in line with the RBI’s intention to free the
last administered interest rate in the economy. According to the central bank, they will review the
policy of deregulating the saving bank deposit rate depending on feedback.
The impact of the rate hikes will transmit into bank lending and deposit rates. We think that
bank lending rates will rise by at least 50 bp due to the repo rate hike. With rates moving up and
inflation expectations to be impacted by the policy move, we think real interest rates will move
into positive territory gradually.
The operating procedure of monetary policy was changed with the repo becoming the single
policy rate (see India: Liquidity—not yet good times, Asia Economics Analyst 11/07, April 7,
2011). A new Marginal Standing Facility (MSF) was introduced for banks to borrow up to 1% of
their net demand and time liabilities. The rate of interest on this would be 100 bp above the repo
rate, which is higher than the original proposal of repo +50 bp. The revised Liquidity Adjustment
Facility (LAF) corridor will have a fixed width of 200 bp. The repo rate will be in the middle. The
reverse repo rate will be 100 bp below it, and the MSF rate 100 bp above it. The MSF will come
into effect from the fortnight beginning May 7, 2011.
The impact of the new operating procedures would be to curb volatility and make the policy
rate more relevant in determining short-term money market rates rather than liquidity. This
would improve the transmission of monetary policy. The boundaries of the reverse repo and MSF
rate within which the overnight rate would move, would increase transparency. The MSF also
improves flexibility when the system is in significant liquidity deficit mode. Further, using
Statutory Liquidity Ratio (SLR) securities as collateral for borrowing at the MSF, enhances the
liquidity attributes of SLR securities, which banks have to maintain anyway. The restriction of the
LAF to 1% of net demand and time liabilities makes it as an equilibrating mechanism without
overburdening it with excessive injection or absorption. We think the overnight call rate would
fluctuate between the repo and the MSF rate going forward. Currently, however, with liquidity not
significantly in deficit, the overnight call rate would likely remain close to the repo rate.
The RBI also announced important initiatives for the development of financial markets and
regulatory measures for banks. In the area of financial markets, the RBI has taken three
important initiatives. First, it will shortly issue the final guidelines on credit default swaps (CDS).
Second, the period of short sale in government securities will be extended from the existing five
days to a maximum of three months. Third, foreign institutional investors (FIIs) will be allowed to
cancel and rebook up to 10% of the market value of the portfolio as at the beginning of the
financial year. For commercial banks, the RBI has taken a couple of regulatory measures. First,
the provisioning requirements on certain categories of non-performing advances and restructured
advances will be enhanced. Second, investment by banks in liquid schemes of debt oriented
mutual funds will be subject to a prudential cap of 10% of their net worth as of March 31 of the
previous year.
We welcome the RBI’s hawkish stance and actions. We have been arguing for decisive action
by the RBI due to high and persistent inflation, negative real rates, a higher-than-budgeted fiscal
deficit and the need to contain second round effects of the food and energy shocks (see India:
Raising inflation and rate forecasts, reducing GDP, Asia Economics Analyst 11/08, April 21,
2011). There was a fear that the RBI would fall behind the curve, lose focus on the fight against
inflation, and therefore its hard-won credibility. By showing resolve, we think that it will dampen
inflation expectations and restore confidence.
The RBI’s action and statements suggest to us that it will continue the hiking cycle to stem
inflationary risks. The larger-than-consensus increase in repo, increase in savings rate and in the
MSF rate to repo +100 bp are all hawkish. As the annual policy statement stated, “While the
persistence of inflation over the next few months has been incorporated into this policy, the
Reserve Bank will continue to persevere with its anti-inflationary stance.” We reiterate our higherthan-consensus view of 75 bp of rate hikes going forward.
The expected large sell-offs today in the equity markets and the swap curve notwithstanding,
we still think that the extent of near-term tightening has not been completely priced in yet.
Our strategists remain underweight on equities given macro risks. On the INR, given the
conflicting forces of capital outflows from equity markets suggesting weakness and higher yields
suggesting strength, we think it will likely depreciate against the USD, and retain our 3, 6 and 12-
month USD/INR targets at 46, 46.2 and 47 respectively.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
The Reserve Bank of India acts aggressively,
signals more hikes to come
The Reserve Bank of India (RBI) hiked the repo rate by 50 bp and the reverse repo rate by
50 bp, in line with our expectations, but ahead of Bloomberg consensus expectations. 18 out of
25 economists polled by Bloomberg were expecting a 25 bp hike. The bond market was pricing in
close to a 50-bp hike. After today’s decision, the reverse repo rate moves up to 6.25% and the
repo rate to 7.25%. The cash reserve ratio (CRR) remains at 6.00%.
The RBI forecasts inflation at 6% by March 2012 and GDP growth at 8% for FY12. With
regards to the trajectory, inflation is expected to remain at an elevated level in the first half of
FY12, before gradually moderating in the second half. The RBI thought that all the risks to
inflation currently are to the upside. The RBI’s baseline projection for real GDP growth for FY12
is 8%. These forecasts are in line with our own forecasts of 7.8% for GDP growth and 7.5%
average WPI inflation for FY12.
The RBI also increased the administered savings rate of banks by 50 bp, increasing them to
4% from 3.5% earlier with immediate effect. This is in line with the RBI’s intention to free the
last administered interest rate in the economy. According to the central bank, they will review the
policy of deregulating the saving bank deposit rate depending on feedback.
The impact of the rate hikes will transmit into bank lending and deposit rates. We think that
bank lending rates will rise by at least 50 bp due to the repo rate hike. With rates moving up and
inflation expectations to be impacted by the policy move, we think real interest rates will move
into positive territory gradually.
The operating procedure of monetary policy was changed with the repo becoming the single
policy rate (see India: Liquidity—not yet good times, Asia Economics Analyst 11/07, April 7,
2011). A new Marginal Standing Facility (MSF) was introduced for banks to borrow up to 1% of
their net demand and time liabilities. The rate of interest on this would be 100 bp above the repo
rate, which is higher than the original proposal of repo +50 bp. The revised Liquidity Adjustment
Facility (LAF) corridor will have a fixed width of 200 bp. The repo rate will be in the middle. The
reverse repo rate will be 100 bp below it, and the MSF rate 100 bp above it. The MSF will come
into effect from the fortnight beginning May 7, 2011.
The impact of the new operating procedures would be to curb volatility and make the policy
rate more relevant in determining short-term money market rates rather than liquidity. This
would improve the transmission of monetary policy. The boundaries of the reverse repo and MSF
rate within which the overnight rate would move, would increase transparency. The MSF also
improves flexibility when the system is in significant liquidity deficit mode. Further, using
Statutory Liquidity Ratio (SLR) securities as collateral for borrowing at the MSF, enhances the
liquidity attributes of SLR securities, which banks have to maintain anyway. The restriction of the
LAF to 1% of net demand and time liabilities makes it as an equilibrating mechanism without
overburdening it with excessive injection or absorption. We think the overnight call rate would
fluctuate between the repo and the MSF rate going forward. Currently, however, with liquidity not
significantly in deficit, the overnight call rate would likely remain close to the repo rate.
The RBI also announced important initiatives for the development of financial markets and
regulatory measures for banks. In the area of financial markets, the RBI has taken three
important initiatives. First, it will shortly issue the final guidelines on credit default swaps (CDS).
Second, the period of short sale in government securities will be extended from the existing five
days to a maximum of three months. Third, foreign institutional investors (FIIs) will be allowed to
cancel and rebook up to 10% of the market value of the portfolio as at the beginning of the
financial year. For commercial banks, the RBI has taken a couple of regulatory measures. First,
the provisioning requirements on certain categories of non-performing advances and restructured
advances will be enhanced. Second, investment by banks in liquid schemes of debt oriented
mutual funds will be subject to a prudential cap of 10% of their net worth as of March 31 of the
previous year.
We welcome the RBI’s hawkish stance and actions. We have been arguing for decisive action
by the RBI due to high and persistent inflation, negative real rates, a higher-than-budgeted fiscal
deficit and the need to contain second round effects of the food and energy shocks (see India:
Raising inflation and rate forecasts, reducing GDP, Asia Economics Analyst 11/08, April 21,
2011). There was a fear that the RBI would fall behind the curve, lose focus on the fight against
inflation, and therefore its hard-won credibility. By showing resolve, we think that it will dampen
inflation expectations and restore confidence.
The RBI’s action and statements suggest to us that it will continue the hiking cycle to stem
inflationary risks. The larger-than-consensus increase in repo, increase in savings rate and in the
MSF rate to repo +100 bp are all hawkish. As the annual policy statement stated, “While the
persistence of inflation over the next few months has been incorporated into this policy, the
Reserve Bank will continue to persevere with its anti-inflationary stance.” We reiterate our higherthan-consensus view of 75 bp of rate hikes going forward.
The expected large sell-offs today in the equity markets and the swap curve notwithstanding,
we still think that the extent of near-term tightening has not been completely priced in yet.
Our strategists remain underweight on equities given macro risks. On the INR, given the
conflicting forces of capital outflows from equity markets suggesting weakness and higher yields
suggesting strength, we think it will likely depreciate against the USD, and retain our 3, 6 and 12-
month USD/INR targets at 46, 46.2 and 47 respectively.
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