RBI 3QFY2011 Monetary Policy Review : Angel Broking

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3QFY2011 Monetary Policy Review

RBI hikes repo and reverse repo rates by 25bp each

RBI hikes repo and reverse repo rates by 25bp each

􀂃 Hikes repo rate by 25bp to 6.5%

􀂃 Hikes reverse repo rate by 25bp to 5.5%

􀂃 Keeps cash reserve ratio unchanged at 6.0%

􀂃 Additional liquidity support under the LAF window up to 1% of NDTL

extended till April 8, 2011

Focus on anchoring inflationary expectations

The RBI in its third quarter monetary policy review raised the repo and reverse

repo rates by 25bp each to 6.5% and 5.5%, respectively, with an objective to

control inflationary expectations. The RBI stated that its current monetary policy

stance is intended to:

􀂃 Contain the spill-over of high food and fuel inflation into generalised inflation

and anchor inflationary expectations, while being prepared to respond to any

further build-up of inflationary pressures.

􀂃 Maintain an interest rate regime consistent with price, output and financial

stability

􀂃 Manage liquidity to ensure that it remains broadly in balance, with neither a

surplus diluting monetary transmission nor a deficit choking off fund flows

Upward bias for broader domestic interest rates

With credit growth expected to sustain above 19–20% for FY2011 and deposit

growth languishing at 16.5% yoy, almost all banks have already increased their

retail fixed deposit rates (in most cases above 100bp) in 3QFY2011. However,

the gap between credit and deposit has kept liquidity in the deficit since

September 2010. Accordingly, over the course of the year, we expect deposit and

lending rates to remain on an upward trajectory.

Macro-fundamentals suggest possible rupee depreciation

The gap between savings and investments is being plugged by the high current

account deficit at present. The RBI has expressed its concern over India’s high

current account deficit, which it expects would touch 3.5% of GDP in FY2011.

In fact, combined with the fact that inflation is also likely to be as high as 7% for

FY2011, both these macro parameters point towards a rupee depreciation

in our view.

Focus on anchoring inflationary expectations

In April last year, we had set a target of 7% for the repo rate, citing a need for a

front-ended increase in policy rates in this upcycle, following the sharp decline in

policy rates post the Lehman crisis. While the RBI had continued to increase policy

rates regularly up to 6.25% on the repo front, it took a pause in December 2010,

as tight liquidity was leading to a naturally tight monetary environment.

However, as of December 2010, the WPI climbed once again to a high level of

8.4%. The contribution of food and textiles to the 8.4% WPI was 47%, while oil’s

contribution to overall inflation increased to 19%. Contribution of other items

(having 55% weightage in the WPI index) increased to 34% in December 2010 due

to increased prices of coal, metals, electricity and wood products among others,

indicating that inflation is becoming more broad-based. In fact, the RBI itself has

hiked its inflation projection by the end of FY2011 to 7%, way above its comfort

zone. Moreover, while the RBI expects inflation to start moderating in 1QFY2012,

it has noted upside risks to inflation as food inflation has remained at an elevated

level for about two years and the prospect of it spilling over to the general inflation

process is rapidly becoming a reality.

Therefore, resumption of monetary policy tightening by the RBI to anchor inflation

expectations is appropriate at this juncture. Policy and broader interest rates are in

any case well below peak levels, leaving ample scope for gradual monetary

tightening, without adversely affecting the growth outlook.

Domestic supply-side inflation does not mean policy rates can be

left unchanged

Though the problem of inflation seems to be more affected on account of

supply-side issues; internationally, central banks have historically raised policy

rates in the scenario of rising inflation even if economic growth is not so high (as

can be seen in Exhibit 3). For instance, during mid-1970s and early 1980s, crude

oil prices jumped up sharply, which hampered economic growth and at the same

time resulted in high inflation in the US. The US Federal Reserve (US Fed)

aggressively resorted to monetary tightening despite the recessionary environment

and essentially a supply-side inflation issue. Hence, considering the upward

revision in inflation projection from 5.5% to 7.0% by FY2011-end, we believe the

RBI will continue its gradual tightening of policy rates going forward, maintaining a

hawkish stance.

We believe that domestic monetary policy would indeed be ineffective in

addressing increases in the prices of global commodities such as crude and

metals. As far as this kind of inflation is concerned, we believe curbing domestic

demand and growth would not be the answer and, in our view, the RBI would take

cognizance of the same. Rising global commodity prices create a problem for the

domestic economy as a whole, rather than creating adverse effects for different

population segments in an inequitable manner. The country needs to find ways of

meeting its global resource requirements more sustainably, rather than choosing to

tighten monetary policy to tackle the same. However, at present, evidently, global

commodities are only a small part of the problem and, at present, the fiscal and

monetary policy challenge is clearly to address domestic-driven inflation,

emanating from both the demand and supply side.

Macro-fundamentals suggest possible rupee depreciation

The gap between savings and investments is being plugged by the high current

account deficit at present. The RBI has expressed its concern over India’s high

current account deficit, which it expects would touch 3.5% of GDP for FY2011.

In fact, combined with the fact that inflation is also likely to be as high as 7% for

FY2011, both these macro parameters point towards a rupee depreciation in our

view. We believe this could provide the much-needed impetus to export growth,

leading to a more sustainable balance of payment situation. At the same time, this

should help normalise the liquidity situation to an extent, as one of the missing

sources of reserve money creation in this cycle so far has been net accretion in our

forex reserves.

Upward bias for broader domestic interest rates

As on December 31, 2010, the yoy growth rate in credit stood at 24.4% compared

to 18.0% in May 2010, much above the indicative projection of 20%. We expect

credit growth to sustain above 19–20% for FY2011. At the same time, deposit

growth has remained flattish at 16.5% yoy compared to 16.1% yoy during the

corresponding period last year.

Almost all banks increased their retail fixed deposit rates (in most cases above

100bp) in 3QFY2011, leading to a ~200bp increase in deposit growth post that

period. However, the gap between credit and deposit has kept liquidity in the

deficit since September 2010. Accordingly, over the course of the year, we expect

deposit and lending rates to remain on an upward trajectory

Banking sector outlook – High CASA banks to outperform

We expect the banking sector to be amongst the strongest performers over the next

two years, with at least 20% credit growth for the sector as a whole, driven by

strong GDP prospects, well-below-peak (albeit rising) domestic interest rates and

increasing risk capital inflows from abroad. Data from the last cycle indicates that

banking stocks gave negative returns, on an absolute basis, when interest rates

were falling post the Lehman crisis, since interest rates were merely symptomatic of

a declining economic environment when markets as a whole were falling. On the

other hand, the banking sector gave handsome returns during the upcycle from

2003, even though interest rates were rising–concomitant to strong GDP growth.

However, on a relative basis, given the rising interest rates, we prefer banks with a

high CASA ratio and lower-duration investment book. Broadly, this combination is

available in large banks, viz. ICICI Bank, Axis Bank and SBI. We expect these

banks to outperform on account of their strong core competitiveness and likelihood

of credit and CASA market share gains, driven by strong capital adequacy and

robust branch expansion. Generally, we expect mid-size banks to underperform on

the net interest income front from 4QFY2011 and expect stock returns to reflect the

same. Taking into account valuations, our top picks are Axis Bank, ICICI Bank and

SBI among large-cap banks. Amongst smaller banks, we like Indian Bank, Dena

Bank, Federal Bank and Jammu & Kashmir Bank.