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Monetary Policy Review.

Repo rate cut by 50bp

Key highlights

n  Reduces repo rate by 50bp to 8.0% (Repo: 8.0%; Reverse Repo: 7.0%; MSF: 9.0%)

n  Keeps SLR and CRR unchanged at 24.0% and 4.75%, respectively

Rate cuts justified; RBI’s move mirrors improved macroeconomic environment conditions

The Reserve Bank of India (RBI) reduced the repo rate by 50bp as against market‘s expectations of 25bp, citing slowdown in growth and headroom provided by moderating core inflation as the primary motivators behind the larger-than-expected reduction in policy rates. Inflation pressures have abated considerably over the past six months (fall of ~300bp in WPI levels in 2HFY2012) and even average inflation levels for FY2013 are expected to be down by 150bp (even after factoring in electricity and fuel price hikes) compared to the levels prevailing during most part of FY2011 and FY2012. The significant moderation in inflation levels, in our view, was clearly creating headroom for interest rates to come down and we believe RBI’s move to reduce policy rates by 50bp mirrors these macro conditions. We expect broader lending and deposit rates to inch down by 50bp in the coming months, as lower inflation enables higher financial savings and improved liquidity conditions for banks.

Although further scope for rate cuts limited, FY2013 estimated to be healthier than FY2012

The RBI has appropriately also kept inflation within its radar to keep inflation expectations anchored, pointing out that potential GDP growth is likely to be closer to 7.5%. Hence, we believe the overall headroom for interest rates to come down over the course of the year is likely to be moderate 75-100bp. Having said that, declining inflation levels (150bp decline further expected during FY2013) and consequent reduction in interest rates and improvement in financial savings should lead to a healthier macroeconomic environment in FY2013 compared to FY2012, which is expected to be positive for the overall corporate earnings growth outlook, especially for rate-sensitive sectors such as banks and infrastructure.

Banks set to benefit from lower interest rates

The 50bp reduction in repo rate is expected to translate into similar lending rate cuts by banks in the coming months. The reduction in deposit rates could lag the reduction in lending rates, which could create some pressures on the margins of banks in the immediate next few months. However, on the back of expected pick up in deposit accretion and improving liquidity, we expect cost of funds for banks to also head lower with a slight lag, leading to an overall stable outlook for FY2013 margins. Also, lower interest servicing costs for borrowers should eventually aid in reducing asset-quality headwinds being currently faced by the sector, leading to improved earnings outlook for the sector in FY2013.

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Monetary Policy Review