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India EcoView
Inflation and Tight Liquidity:
No Quick Fix, But the Worst
Is Behind Us
In this week’s EcoView, we are taking stock of the
liquidity condition and presenting our views on the
outlook for the cost of capital trend. Considering that
inflation is likely to remain significantly higher than the
RBI’s comfort zone for some time, we believe there is no
quick fix to banking system liquidity and that the cost of
capital will be relatively high for a longer period..
Inflation and Tight Liquidity: No Quick Fix, but the Worst Is Behind Us
Key Points
• Taking stock of liquidity situation: In this note, we
take stock of the liquidity condition and present our
views on the outlook for the cost of capital trend.
Considering that inflation is likely to remain
significantly higher than the Reserve Bank of India’s
(RBI) comfort zone for some time, we believe there
is no quick fix to banking system liquidity and that the
cost of capital will be relatively high for a longer
period.
• Slowing credit demand and rising deposit
growth means cost of capital has peaked: Credit
growth has moderated from the peak of 24.6%
during fortnight ended December 31, 2010, to 19.9%
as of July 1, 2011. Similarly, deposit growth has
accelerated from 14.7% during fortnight ended
December 17, 2010, to 18.4% as of July 1, 2011.
With our view that economic activity will slow further
in 2H11, we believe that credit demand will moderate
further, implying that cost of capital has peaked.
• RBI policy has also entered in the last phase of
tightening: We believe we are in the last leg of
policy rate hikes in the current cycle. Our current
base case expectation is that RBI will hike policy
rates twice before the end of the financial year by
25bp each with first one to be announced on July 26.
However, if global growth environment deteriorates
further, RBI may stop hiking rates earlier than
expected.
• We caution against the conclusion that the cost
of capital will decline meaningfully soon: The
end of tightening is not equal to the easing of liquidity
soon. Given that inflation is likely to remain
significantly higher than the RBI’s comfort zone for a
while and the starting point of the credit-deposit ratio
is already high, we believe banking system liquidity
will remain relatively tight and that the cost of capital
will stay high for a longer period unless growth turns
out be weaker than expected.
Summary
In this note, we take stock of liquidity condition and present our
views on the outlook of cost of capital. Considering that
inflation will likely remain significantly higher than the Reserve
Bank of India’s (RBI) comfort zone for a while, we believe
there is no quick fix to banking system liquidity and that the cost
of capital will be relatively high for a longer period. Having said
that, we believe that slowing economic activity and moderation
in credit demand will mean that deposit rates, which have been
a more important measure of the trend in the cost of capital,
have peaked. Unfortunately, a meaningful reduction in the cost
of capital will be possible only if growth surprises on the
downside. As an aside, we think that investor focus will shift to
downside risks to growth from upside risks to inflation in 2H11.
Banking Liquidity Has Remained Extremely Tight so Far
Since the last quarter of the 2010, banking liquidity has
remained tight due to the persistent gap in bank credit and
deposit growth. This trend pushed the credit-deposit ratio
above the comfort zone of 70-72% (considering banks are
required to invest 24% of their liabilities in government
securities and 6% have to be held as cash reserves with the
Central Bank). Indeed, banking sector credit-deposit has
hovered above 72% since then, requiring RBI to inject liquidity
in the inter-bank market on a daily basis (Exhibit 4).
Blame High Inflation for the Tight Environment so Far
The aggressive rise in government spending that boosted
consumption at a time when the credit crisis pulled investment
(capacity creation) down has been at the heart of India’s
inflation problem (Exhibit 3). Concurrent rises in global
commodity prices and negative real bank deposit rates have
only compounded the inflation problem. Headline inflation has
now been above RBI’s comfort zone of 5-5.5% for 19 months.
We believe the key reason for the recent market-driven
tightening in banking liquidity was due to persistent high
inflation and negative real interest rates affecting deposit
growth at a time when credit growth was accelerating.
Liquidity Condition to Improve Slightly as Credit Growth Is
Slowing and…
So far, in our view, the policy makers have been focused on
generating growth primarily via loose fiscal and monetary
policy without paying sufficient attention to the productive
dynamic. However, this approach has made inflation
management difficult and is therefore not sustainable, in our
view. Indeed, a combination of factors – including persistently
high inflation, higher cost of capital, gradual fiscal tightening,
weak global capital market environment and slow pace of
policy effort to boost investments – is beginning to slow growth
(Exhibit 5). We believe this is also beginning to be reflected in
credit demand. Bank credit growth has decelerated from a
peak of 24.6% during fortnight ended December 31, 2010, to
19.9% during the fortnight ending July 1, 2011. We believed
that credit growth would slow further over the next three to four
months to 17-18% YoY
…Higher Deposit Rates Beginning to Help Deposit Growth
Tight inter-bank liquidity had pushed banks to lift deposit rates
closer to 11-year high levels of 9.0-9.5% (one- to two-year
maturity) by February 2011 from 6% in June 2010. Banks’
hiked deposit rates aggressively between December 2010 and
February 2011. We believe that with a lag this rise in deposit
rates is beginning to help revive deposit growth from the trough
of 14.7% during fortnight ended December 17, 2010, to 18.4%
recently. We expect deposit growth to improve gradually as
inflation expectations moderate. Hence, we believe that a
combination of slowing credit demand and a steady rise in
deposit growth will help ease tightness in the banking liquidity
from September 2011 somewhat.
However, High Starting Point of C/D Ratio Means Liquidity
Easing Will Be Very Slow
We believe this cycle is unusual in the sense that even post the
credit crisis-led growth slowdown, the starting point of loan
deposit ratio was relatively high at 69-70% in the middle of
2009. Acceleration in credit and slowing deposit growth has
since pushed credit-deposit ratio to 74-75%. Hence, we believe
that the improvement in liquidity conditions will be gradual and
limited. Seasonal aspect should reduce credit deposit ratio to
about 71.5-73% during September to November 2011, and
then again rise during December 2011-March-2012 (Exhibit 9).
Hence, unless credit growth surprises on the downside
because economic activity slows sharply, we believe
conditions will remain relatively tight through to March 2012. A
factor that can potentially help improve liquidity conditions
without a major deceleration in credit demand is a large spike in
total capital inflows to US$100 billion plus from the current run
rate of US$50-60 billion. While this is not an impossible
outcome, it is not our base-case forecast.
Can RBI Take Measures to Improve Liquidity?
Clearly, RBI has the tools to ease liquidity conditions by way of
a reduction in the cash reserve ratio or buy back of government
securities. However, the starting point of inflation and current
account deficit does not provide that comfort to RBI to be using
these tools without seeing clear signs of major deceleration in
growth or potential spike in inter-bank rate above the new MSF
(Marginal Standing Facility)1 rate of 8.5% due to capital
outflows.
1
Marginal Standing facility: RBI has announced an additional borrowing window
for banks which will provide liquidity at 100bp above the repo rate in times of
extreme shortfall in interbank liquidity
What Is the Outlook on Policy Rates?
We expect the inflation outlook to be challenging over the next
six to eight months. Headline Wholesale Price Index (WPI)
inflation rate was 9.4% and core inflation (manufactured
non-food products inflation) at 7.2% as per government’s
provisional estimates in June 2011. However, we must note
that the government has been persistently revising the
provisional estimates by 80-100bp over the last few months.
We expect the provisional headline WPI inflation rate to remain
around 8.5-9% until November and ease to around 8% in
December but still stay around 7-8% in 1Q12 unless global
commodity prices decline meaningfully over the next few
months.
On policy response, we believe we are in the last leg of policy
rate hikes in the current cycle. In our base case, we expect the
RBI to hike policy rates twice before the end of the financial
year by 25bp each. While we assign high probability for a 25bp
hike on July 26, we believe the outlook for the second 25bp
hike will depend on the events in the developed world. We
believe that if the sovereign debt concerns in Europe or US
result in meaningful risk aversion in the global financial markets
and therefore increase the downside risks to global growth,
RBI could pause earlier than expected. In its last monetary
policy statement, while RBI mentioned that “the monetary
policy stance remains firmly anti-inflationary”, the RBI has also
commented highlighting the need to watch the potential shift in
global environment. The statement said: “while the Reserve
Bank needs to continue with its anti-inflationary stance, the
extent of policy action needs to balance the adverse
movements in inflation with recent global developments and
their likely impact on the domestic growth trajectory." In our
view, this would imply that if there is any major deterioration in
the global growth environment and global commodity prices
correct meaningfully (like oil prices dipping to US$90/bbl or so),
then RBI will likely stop hiking policy rates.
Deposit Rates and Banking Liquidity Conditions More
Important
As we have been mentioning, considering that market rates
have been moving ahead of policy rates, in the current cycle
bank deposit rates are more important as an indicator of
monetary tightening than RBI policy rates. Indeed, the last
75bp rise in policy rates had no impact on deposit rates. As
discussed above, we believe that moderation in growth in
credit is beginning to help liquidity condition. We do not expect
a further rise in bank deposit rates, and if credit slows
meaningfully, banks will begin to reduce deposit rates over the
next three to five months.
Bottom line: We believe that moderation in credit growth and
an improvement in deposit growth mean that the trend in the
cost of capital appears to have peaked. However, we caution
against the simplistic conclusion from this that the cost of
capital will begin to decline meaningfully soon.
Unfortunately, a meaningful reduction in the cost of capital will
be possible only if growth disappoints to the downside. With the
cost of capital likely to remain higher for longer, we remain
focused on downside risks to growth.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India EcoView
Inflation and Tight Liquidity:
No Quick Fix, But the Worst
Is Behind Us
In this week’s EcoView, we are taking stock of the
liquidity condition and presenting our views on the
outlook for the cost of capital trend. Considering that
inflation is likely to remain significantly higher than the
RBI’s comfort zone for some time, we believe there is no
quick fix to banking system liquidity and that the cost of
capital will be relatively high for a longer period..
Inflation and Tight Liquidity: No Quick Fix, but the Worst Is Behind Us
Key Points
• Taking stock of liquidity situation: In this note, we
take stock of the liquidity condition and present our
views on the outlook for the cost of capital trend.
Considering that inflation is likely to remain
significantly higher than the Reserve Bank of India’s
(RBI) comfort zone for some time, we believe there
is no quick fix to banking system liquidity and that the
cost of capital will be relatively high for a longer
period.
• Slowing credit demand and rising deposit
growth means cost of capital has peaked: Credit
growth has moderated from the peak of 24.6%
during fortnight ended December 31, 2010, to 19.9%
as of July 1, 2011. Similarly, deposit growth has
accelerated from 14.7% during fortnight ended
December 17, 2010, to 18.4% as of July 1, 2011.
With our view that economic activity will slow further
in 2H11, we believe that credit demand will moderate
further, implying that cost of capital has peaked.
• RBI policy has also entered in the last phase of
tightening: We believe we are in the last leg of
policy rate hikes in the current cycle. Our current
base case expectation is that RBI will hike policy
rates twice before the end of the financial year by
25bp each with first one to be announced on July 26.
However, if global growth environment deteriorates
further, RBI may stop hiking rates earlier than
expected.
• We caution against the conclusion that the cost
of capital will decline meaningfully soon: The
end of tightening is not equal to the easing of liquidity
soon. Given that inflation is likely to remain
significantly higher than the RBI’s comfort zone for a
while and the starting point of the credit-deposit ratio
is already high, we believe banking system liquidity
will remain relatively tight and that the cost of capital
will stay high for a longer period unless growth turns
out be weaker than expected.
Summary
In this note, we take stock of liquidity condition and present our
views on the outlook of cost of capital. Considering that
inflation will likely remain significantly higher than the Reserve
Bank of India’s (RBI) comfort zone for a while, we believe
there is no quick fix to banking system liquidity and that the cost
of capital will be relatively high for a longer period. Having said
that, we believe that slowing economic activity and moderation
in credit demand will mean that deposit rates, which have been
a more important measure of the trend in the cost of capital,
have peaked. Unfortunately, a meaningful reduction in the cost
of capital will be possible only if growth surprises on the
downside. As an aside, we think that investor focus will shift to
downside risks to growth from upside risks to inflation in 2H11.
Banking Liquidity Has Remained Extremely Tight so Far
Since the last quarter of the 2010, banking liquidity has
remained tight due to the persistent gap in bank credit and
deposit growth. This trend pushed the credit-deposit ratio
above the comfort zone of 70-72% (considering banks are
required to invest 24% of their liabilities in government
securities and 6% have to be held as cash reserves with the
Central Bank). Indeed, banking sector credit-deposit has
hovered above 72% since then, requiring RBI to inject liquidity
in the inter-bank market on a daily basis (Exhibit 4).
Blame High Inflation for the Tight Environment so Far
The aggressive rise in government spending that boosted
consumption at a time when the credit crisis pulled investment
(capacity creation) down has been at the heart of India’s
inflation problem (Exhibit 3). Concurrent rises in global
commodity prices and negative real bank deposit rates have
only compounded the inflation problem. Headline inflation has
now been above RBI’s comfort zone of 5-5.5% for 19 months.
We believe the key reason for the recent market-driven
tightening in banking liquidity was due to persistent high
inflation and negative real interest rates affecting deposit
growth at a time when credit growth was accelerating.
Liquidity Condition to Improve Slightly as Credit Growth Is
Slowing and…
So far, in our view, the policy makers have been focused on
generating growth primarily via loose fiscal and monetary
policy without paying sufficient attention to the productive
dynamic. However, this approach has made inflation
management difficult and is therefore not sustainable, in our
view. Indeed, a combination of factors – including persistently
high inflation, higher cost of capital, gradual fiscal tightening,
weak global capital market environment and slow pace of
policy effort to boost investments – is beginning to slow growth
(Exhibit 5). We believe this is also beginning to be reflected in
credit demand. Bank credit growth has decelerated from a
peak of 24.6% during fortnight ended December 31, 2010, to
19.9% during the fortnight ending July 1, 2011. We believed
that credit growth would slow further over the next three to four
months to 17-18% YoY
…Higher Deposit Rates Beginning to Help Deposit Growth
Tight inter-bank liquidity had pushed banks to lift deposit rates
closer to 11-year high levels of 9.0-9.5% (one- to two-year
maturity) by February 2011 from 6% in June 2010. Banks’
hiked deposit rates aggressively between December 2010 and
February 2011. We believe that with a lag this rise in deposit
rates is beginning to help revive deposit growth from the trough
of 14.7% during fortnight ended December 17, 2010, to 18.4%
recently. We expect deposit growth to improve gradually as
inflation expectations moderate. Hence, we believe that a
combination of slowing credit demand and a steady rise in
deposit growth will help ease tightness in the banking liquidity
from September 2011 somewhat.
However, High Starting Point of C/D Ratio Means Liquidity
Easing Will Be Very Slow
We believe this cycle is unusual in the sense that even post the
credit crisis-led growth slowdown, the starting point of loan
deposit ratio was relatively high at 69-70% in the middle of
2009. Acceleration in credit and slowing deposit growth has
since pushed credit-deposit ratio to 74-75%. Hence, we believe
that the improvement in liquidity conditions will be gradual and
limited. Seasonal aspect should reduce credit deposit ratio to
about 71.5-73% during September to November 2011, and
then again rise during December 2011-March-2012 (Exhibit 9).
Hence, unless credit growth surprises on the downside
because economic activity slows sharply, we believe
conditions will remain relatively tight through to March 2012. A
factor that can potentially help improve liquidity conditions
without a major deceleration in credit demand is a large spike in
total capital inflows to US$100 billion plus from the current run
rate of US$50-60 billion. While this is not an impossible
outcome, it is not our base-case forecast.
Can RBI Take Measures to Improve Liquidity?
Clearly, RBI has the tools to ease liquidity conditions by way of
a reduction in the cash reserve ratio or buy back of government
securities. However, the starting point of inflation and current
account deficit does not provide that comfort to RBI to be using
these tools without seeing clear signs of major deceleration in
growth or potential spike in inter-bank rate above the new MSF
(Marginal Standing Facility)1 rate of 8.5% due to capital
outflows.
1
Marginal Standing facility: RBI has announced an additional borrowing window
for banks which will provide liquidity at 100bp above the repo rate in times of
extreme shortfall in interbank liquidity
What Is the Outlook on Policy Rates?
We expect the inflation outlook to be challenging over the next
six to eight months. Headline Wholesale Price Index (WPI)
inflation rate was 9.4% and core inflation (manufactured
non-food products inflation) at 7.2% as per government’s
provisional estimates in June 2011. However, we must note
that the government has been persistently revising the
provisional estimates by 80-100bp over the last few months.
We expect the provisional headline WPI inflation rate to remain
around 8.5-9% until November and ease to around 8% in
December but still stay around 7-8% in 1Q12 unless global
commodity prices decline meaningfully over the next few
months.
On policy response, we believe we are in the last leg of policy
rate hikes in the current cycle. In our base case, we expect the
RBI to hike policy rates twice before the end of the financial
year by 25bp each. While we assign high probability for a 25bp
hike on July 26, we believe the outlook for the second 25bp
hike will depend on the events in the developed world. We
believe that if the sovereign debt concerns in Europe or US
result in meaningful risk aversion in the global financial markets
and therefore increase the downside risks to global growth,
RBI could pause earlier than expected. In its last monetary
policy statement, while RBI mentioned that “the monetary
policy stance remains firmly anti-inflationary”, the RBI has also
commented highlighting the need to watch the potential shift in
global environment. The statement said: “while the Reserve
Bank needs to continue with its anti-inflationary stance, the
extent of policy action needs to balance the adverse
movements in inflation with recent global developments and
their likely impact on the domestic growth trajectory." In our
view, this would imply that if there is any major deterioration in
the global growth environment and global commodity prices
correct meaningfully (like oil prices dipping to US$90/bbl or so),
then RBI will likely stop hiking policy rates.
Deposit Rates and Banking Liquidity Conditions More
Important
As we have been mentioning, considering that market rates
have been moving ahead of policy rates, in the current cycle
bank deposit rates are more important as an indicator of
monetary tightening than RBI policy rates. Indeed, the last
75bp rise in policy rates had no impact on deposit rates. As
discussed above, we believe that moderation in growth in
credit is beginning to help liquidity condition. We do not expect
a further rise in bank deposit rates, and if credit slows
meaningfully, banks will begin to reduce deposit rates over the
next three to five months.
Bottom line: We believe that moderation in credit growth and
an improvement in deposit growth mean that the trend in the
cost of capital appears to have peaked. However, we caution
against the simplistic conclusion from this that the cost of
capital will begin to decline meaningfully soon.
Unfortunately, a meaningful reduction in the cost of capital will
be possible only if growth disappoints to the downside. With the
cost of capital likely to remain higher for longer, we remain
focused on downside risks to growth.
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