First Quarter Review of Monetary Policy 2011-12 - RBI stumps with 50-bps hike; Inflation target hiked to 7%

The RBI revealed its super hawkish monetary policy for the first quarter 2011-12 by raising the policy repo rate under the liquidity adjustment facility (LAF) by 50 bps.  The repo rate will now move to 8 per cent. This is 11^th successive hike since Mar 2010 and the fastest monetary accommodative uncovering in the world. Consequently, the reverse repo rate under the LAF, at a spread of repo rate minus 100 bps gets adjusted to 7 per cent. Similarly, the Marginal Standing Facility (MSF), determined at a spread of 100 bps above the repo rate will move up to 9 per cent.

Repo rate is the rate at which RBI lends to banks and Reverse repo rate is the rate at which RBI borrows from banks. The new term Marginal Standing Facility (MSF) is the additional borrowing window for banks set up at 100 bps above repo rate and they can borrow overnight up to one per cent of their respective Net Demand and Time Liabilities (NDTL).

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RBI 3rd Quarter Monetary Policy Review 2010-11 – Containing inflation to remain predominant objective

The RBI monetary policy soap opera verdict is out. The mixed global recoveries rather still subdued and the inflationary pressures in emerging market economies (EMEs) including India has been on the top of the radar of RBI in its Third Quarter Monetary Policy Review 2010-11. From the earlier stance of growth-inflation dynamics, the RBI moved to anchor the inflationary expectations likely due to sharp increase in the prices of primary food articles and the recent spurt in global oil prices.

Key Policy Measures:

•  Repo rate, the rate at which banks borrow from RBI, up by 25 bps at 6.5 per cent
•  Reverse repo rate, the rate at which the RBI lends to banks, up by 25 bps at 5.5 per cent
•  Cash Reserve Ratio (CRR), the portion of deposit that banks keep with the central bank retained at 6.0 per cent
• The inflation target revised upwards to 7 per cent from 5.5 per cent for march-end 2011
• The baseline projection of real GDP growth retained at 8.5 per cent with an upward bias.

Domestic Outlook

The domestic economy is on strong trajectory path as revealed by the 8.9 per cent GDP growth in the first half of 2010-11 powered mainly by domestic factors including strong consumption. The strong agricultural output on satisfactory kharif production and higher rabi sowing will contribute significantly to overall GDP growth in 2010-11. The industrial output also showed buoyant figures; however, the significant volatility adds uncertainty to the outlook.

Inflationary Concerns

The headline inflation as measured by WPI remained uncomfortably high since Jan 2010. Although it moderated between Aug and Nov 2010, it reversed in Dec 2010 mainly due to sharp increase in prices of vegetables specially onion, tomatoes, garlic etc and petrol prices. The current inflation level is also contributed by structural demand-supply mismatches in other cereal items. Considering all the scenarios, the baseline projection of WPI inflation for March 2011 has been revised upwards to 7 per cent from 5.5 per cent earlier. The sources of price pressure – fuel and non-fuel commodity prices and some food items could be non-responsive to RBI monetary policy actions. Going forward, the price level will depend how the global and domestic prices evolve.

Liquidity – still in deficit mode

Since the outflows caused due to 3G and WIMAX payments, the liquidity remained in deficit mode in the financial system. Also, the sluggish deposit growth, far below the RBI projection along with the non-food credit growth of 24.4 per cent worsened the liquidity in the system. Meanwhile, the RBI also intervened by cutting SLR by 1 per cent and initiated OMO transactions worth Rs. 67,000 crore. The additional liquidity support to banks up to 1 per cent of NDTL has been extended up to April 08, 2011. Under this, the bank may seek waiver of penal interest purely as an ad hoc measure. The 2^nd LAF will be conducted on a daily basis up to April 08, 2011.

Burgeoning CAD (Current Account Deficits)

The current CAD expected to be around 3.5 per cent of GDP is not sustainable as feared by RBI. CAD, an outcome of net exports and imports may get worsened further if the global recovery improves. Till now, the capital flows, which so far have been broadly sufficient to finance CAD may get adversely affected as the global recovery can trigger the flight to safety.

Global Scenario

There has been a significant improvement in global growth prospects in recent weeks; however, the recoveries are still fragile with uneven scenarios in Euro region and Japan. The deflation fears looming largely on advanced economies got some reprieve with early signs of inflation. The real GDP growth in the US improved to 2.6 per cent in Q3 2010-11 after witnessing a muted growth in 1.7 per cent. The retail sales and corporate capital spending has improved. Unlike in advanced economies, Emerging Market Economies (EME) has been affected by burgeoning inflation trends due to spurt in global food prices including a spurt in crude oil. 

With better signs of sustainable recoveries, the global growth in 2010-11 is anticipated to be less frictional and will show firm signs of sustainable recoveries. With rising prices on increased demand, inflation would be a global concern in 2011.

Why the rate hikes?

The market had been anticipating a tougher stand from RBI as the inflationary issues failed to settle down. While the market had mixed anticipations – 25bps vs 50bps hike, the RBI followed a calibrated approach – hiking the policy rates by 25 bps only – after taking a “comma” stand for few weeks in its policy rate hikes. The current policy rate is still below the pre-crisis level. Since March 2010, it has increased rates by six times. Also, keeping the LAF corridor at 1 per cent, the RBI intended to bring down the volatility in overnight rates within the corridor.

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-          Amar Ranu

Nov 02 policy review eyed

Highlights:

• Amid tight systematic liquidity, the RBI announced a special second LAF, a liquidity window for scheduled commercial banks to borrow to the extent of up to 1.0 per cent of their Net Demand and Time Liabilities (NDTL) as on Oct 08 on all days during Oct 29-Nov 04, 2010. The RBI also announced a special 2-day repo auction under the LAF on Oct 30, 2010 which saw a total borrowing of Rs. 11,025 crore under LAF. The RBI also allowed waiver of penal interest, if any for any shortfall in maintenance of SLR on Oct 30-31, 2010 out of these special facilities.

• The buy-back programme as announced by the government did not draw good responses from the market – with bids worth Rs. 3,174 crore tendered against the notified amount of Rs. 12,000 crore. However, the total amount accepted for buy-back was Rs. 2,148 crore only.

• The benchmark bond seemed to lose its appetite after volume shifted to 8.13% G-Sec 2022 as the market expected that 7.80% G-Sec 2020 may not see any auctions further. However, comments from a Finance Ministry official who hinted that the 10-year bond will retain its benchmark status till fiscal year end led to a swift rally in it. Further, the RBI’s special liquidity window led to fall in yields. The 10-year benchmark paper closed at 8.11, down by 3 bps over the week.

• India’s primary articles’ inflation fell to 16.62 per cent in the week ended Oct 16 from 18.05 per cent in the last week while food articles’ inflation fell to a 50-week low of 13.75 per cent from 15.53 per cent a week before.

• Growth in India’s key infrastructure industries, which constitute 26 per cent of IIP figures fell to a 19-month low of 2.5 per cent in Sept compared to 3.9 per cent and 4.3 per cent in Aug and a year ago respectively.

View & Recommendations:

• The special liquidity window announced by RBI may ease the structural liquidity crisis. The RBI is looking to normalize policy rates given high inflation; however, it feared that the QE-II (Quantitative Easing 2 to be announced by Fed Reserve) may bring more capital inflows into the system which will force the RBI to contain the rupee appreciation. This may lead to inflation hike further.

• The market participants have expected a hike of 25 bps in policy rates to be announced by RBI on Nov 02. The market has already factored into the 25 bps hike in policy rates. So, yields might not move significantly if there is hike in policy rates. However, the government may decide to cancel the auction after which the government bonds may witness a rally.


Broader Perspectives:

Bond Front

The buy-back programme announced by RBI did not draw strong interests from market participants. Bids worth Rs. 3,174 crore were tendered against the notified amount of Rs. 12,000 crore. However, the total amount accepted for buy-back was Rs. 2,148 crore. The securities which are bought back are 8.75% G-Sec 2010, 12.32% G-Sec 2011 and 6.57% G-Sec 2011 for notified amount of Rs. 28.97 crore, Rs. 616.35 crore and Rs. 1,502.97 crore respectively. The inflation continued to remain in uncomfortable zone which may allow the central bank to use all its ammunitions, policy rate hikes being the most prominent one. The RBI policy will be announced just before the much awaited US Federal Reserve announcement regarding the much touted QE-II, or second round of quantitative easing. The probability goes high as the US jobless rate hovered around 10 per cent for a third month in October.

The benchmark yield kept on spiraling and touched its near months high of 8.18 per cent. Meanwhile, the borrowing limit in benchmark bond saw a shift in active trading to other yields. The 10-year benchmark paper closed at 8.11 per cent, down by 3 bps. The 8.13% G-Sec 2022 became the most actively traded securities during the last week.

The tight liquidity scenario, an example of structural liquidity deficit led to a hike in interbank call money markets which rose as high as 12 per cent. During the week, the banks borrowed a net amount of Rs. 4.80 lakh crore against the previous week of Rs. 3.17 lakh crore. The Repo and CBLO rate closed at 6.43 per cent and 7.96 per cent, an increase by 72 bps and 261 bps respectively.

The 1/10 year G-Sec spreads fell to 112 bps from 124 bps a week earlier. And the average G-Sec volume reported was Rs. 47,412 crore compared to Rs. 53,776 crore a week earlier.

Bond Supply

The market didn’t have any central government auctions scheduled for this week; however, the SDL (State Development Loans) auctions raised Rs. 8,601.8 crore as against the notified amount of Rs. 8,226.8 crore with the state of Tamil Nadu exercising the green show option to the tune of Rs. 375 crore.

Liquidity

The systematic liquidity remained in deficit mode which allowed RBI to open an additional liquidity window. The liquidity as measured by bids for reverse repo/repo in the LAF (Liquidity Adjustment Facility) auction of the RBI reported a net borrowing of Rs. 4,80,180 crore or daily average of Rs. 80,030 crore.

Corporate Bonds

The corporate bond yields saw a hike in the concluding week. The 10-year AAA bond ended at a yield of around 8.80 per cent compared to 8.76 per cent in the previous week. Credit spreads moved up with 5-year AAA spreads moving up by a basis point to 69 bps levels.

Source: MOSL

RBI Mid-Sept Monetary Policy Review – Loans to become dearer

The hawkish global economy recovery coupled with high inflationary pressures forced the Central Bank to raise Policy Rates at the pace faster than the market expectations. The Central Bank, RBI in its Mid-Quarter Monetary Policy Review increased the repo rate and reverse repo rate under LAF.


• Repo Rate and Reverse Repo Rate under Liquidity Adjustment Facility (LAF) increased by 25 bps and 50 bps to 6 per cent and 5 per cent respectively, thus, bringing out the LAF rate corridor to 1 per cent.
• Bank Rate and CRR (Cash Reserve Ration) retained at the same level of 6 per cent each

Domestic Scenario
The RBI stressed on that fact that Inflation has become a kind of concern; even the new index of headline inflation as measured by WPI suggests that the monthly average of WPI inflation for Q1 of 2010-11 under the new series at 10.6 per cent was about 50 bps lower than the rate of 11.1 per cent under the old series. Inflation rates have reached its peak and are most likely to remain at the same level for the next few months. However, Food Inflation continues to move northwards and touched 14 per cent in Aug 2010 as per new series.

Another concern that the RBI documented that the negative real interest rates have been affecting deposit growth rates of banks as savers look for higher returns elsewhere. The RBI wanted deposit growth rates to increase as accordingly the bond supply will be a thorough affair in its weekly auctions without any devolvement which may put pressure on yields. The trend suggests that higher deposit growth rate require higher demands for federal bonds as the bank need to maintain the SLR requirement.

The RBI also indicated that higher than expected realizations on 3G and BMA auctions combined with robust tax revenues have virtually eliminated the risk of the fiscal deficit overshooting its target of 5.5 per cent, even after the additional demand for grants from the Central Government have come up in the Parliament. The Water God, Monsoon has revived the growth prospects in Agriculture which will contribute to good rabi harvest.

Liquidity – from a large surplus to deficit
From a surplus mode, the liquidity entered into a deficit mode after the July Policy review, thus, making the repo rate as the operative policy rate. The current hike will prompt many banks to raise the lending and deposit rates which will sustain the strength of the transmission mechanism.

Global Factors
The RBI remained elusive of global circumstances where the slow recovery has halted many advanced economies to hold their rates further for an extended period. This led to massive inflows into developing economies including India. Moreover, the weak global demand coupled with strong domestic demand has increased the trade deficit and the current account deficit has also been widening. However, Europe has demonstrated remarkable resilience; China too bounced back with industrial production and trade numbers reviving sharply. “Overall, even as the global environment continues to be a cause for caution, the big picture has not worsened significantly since July”, said RBI in a press note.

Need for the hike in Policy Rates
Though the hike in policy rates were expected but by increasing the Reverse Repo Rate by 50 bps, higher than the market expectation of 25 bps, the RBI has used this opportunity to reduce the LAF rate corridor, which will reduce the expected volatility in overnight rates. Moreover, it also wanted to reduce the impact of negative real interest rates which led to savers to move to alternate products giving higher returns.

Bond yields laddered to 8 per cent level on devolvement

Highlights
• Benchmark bond 6.35% 2020 yield touched to 8.01 per cent on account of devolvement* in first week auction
• Primary dealers had to devolve Rs. 448 Cr. of 6.35% 2020 paper
• Food inflation rose to 14.50 per cent for data on Mar 27, 2010 against 13.86 per cent observed a week before
• Limits for Ways and Mean Advance (WMA) set at Rs. 30,000 Cr. for first half of FY and Rs. 10,000 Cr. for second half of FY
• Inflationary pressures (data to be available next Thursday) and Industrial Output data to influence the policy review due on April 20, 2010; inflation likely to be in double digits
• Market to witness an auction of Rs. 13,000 Cr. on Government Securities and Rs. 5,800 crore of State Development Loans (SDL) this week

*Devolvement - is a mechanism used by Reserve Bank of India as part of its monetary policy to counter the volatility in the price of Government Securities. Under this mechanism Primary dealers would have to absorb the underwritten amount, when the bid prices are unacceptable to the RBI.

Views & Recommendation:

• The weekly bond issuances are likely to impact the bond prices in a greater way; any further devolvement will put pressure on bond yields.
• Liquid Funds and Ultra Short Term Funds (erstwhile called as Ultra Short Term Funds) would see its yields rising from the current yield as shorter end of yield curve is likely to move up in near future once the policy rates go up.
• Investors having longer investment horizon (more than 2 years) should wait for yields to reach to 8.25-8.5 per cent level and can then invest in Income Funds.

Broad Perspective:

The week started with a cooling in bond yields; the 10-year benchmark 6.35% 2020 G-Sec slipped to 7.80 per cent on Monday, down by 5 bps over its last week closing. However, the sentiments went against the market and the yields rose to its three week highs ahead of first week auction of Rs. 12,000 crore and monetary policy tightening to contain high inflation.
The auction results disappointed the market and the benchmark yield passed 8 per cent mark to close at 8.01 per cent on account of devolvement. It touched to 8.03 per cent level, its highest in more than 17 months and a level it touched on Mar 22, 2010. The auctioned bonds got timid response and primary dealers had to devolve Rs. 448 crore of 6.35% 2020 paper. RBI set the cut-off yield of 7.9645 per cent for the 6.35% 2020 bonds. The other bonds were fully subscribed amidst high demand. Both received demands for more than two times. Due to devolvement, primary dealers demanded high cut-off yields. This week, the choice of securities will decide the momentum of bond yields and primary dealers will demand higher underwriting fees and higher yields in fear of devolvement of securities. Moreover, the subdued response on 6.35% 2020 bond is putting pressure on its existence as the benchmark yield and traders have been demanding for a new benchmark so that they could concentrate on the movement on interest rates instead of choice of a benchmark bond.
Inflationary pressures continue to remain intact; food prices accelerated for second straight week. The inflation based on primary articles rose to 14.50 per cent for the week concluding on Mar 27, 2010 against 13.86 per cent observed a week before. Industrial output data for February due on Monday and March inflation data on next Thursday are the factors which will decide the direction of RBI Policy review due on April 20, 2010.
Liquidity as measured by bids for reverse repo/repo at the Liquidity Adjustment Facility auction went to an average level of Rs. 1 lakh crore against Rs. 2,000 crore reported last week. Overnight rates also remained at the level of reverse repo rates due to high liquidity in the system.
However, Corporate Bonds yields saw an increased activity in the trading circles. Its spread over its counterpart G-Sec slipped in all categories. The 5-year and 10-year corporate bond spread over its counterpart G-Sec slipped to 76 bps and 63 bps from 81 bps and 82 bps respectively. The 10-year Corporate Bond closed at 8.80 per cent for the week concluding on April 09, 2010.
RBI set the limit for Ways and Mean Advance (WMA) at Rs. 30,000 crore for first half of fiscal year (April to September) and Rs. 10,000 crore for second half of fiscal year (October to March). WMA is a window through which the government borrows from RBI to meet mismatches between payment and receipts. Any borrowing within the WMA limit is done at Repo rate and over the WMA limit, it is done at Repo plus 2 per cent.

RBI exits from expansionary policies

The domestic economy has started experiencing its feel-good factor with the encouraging numbers from all ends. However, the global economic outlook scripts a different picture. The abundance liquidity, inflationary pressures and week credit off-take forced the central bank to initiate some precautionary steps.

Keeping in mind to provide a balanced approach to our coupled economy, the Reserve Bank of India (RBI) in its second-quarter review of monetary policy 2009-10 maintained its status-quo on its lending and borrowing rates by keeping repo and reverse-repo rates unchanged at 4.75 per cent and 3.25 per cent respectively. It has also kept the Cash Reserve Ratio (CRR), the portion of deposits which the commercial banks need to keep with the RBI unchanged at 5 per cent. However, the bank has hiked the Statutory Liquidity Ratio (SLR), the amount which the commercial banks need to maintain in the form of cash, government approved securities (G-Secs) and/or gold before providing credit to the borrowers, to 25 per cent from 24 per cent effective from Nov 07, 2009 which will suck up over Rs 30,000 crore from the system. The central bank also aims to reduce the surplus liquidity and fight the higher inflationary expectations, which have been building up following a deficit monsoon (22% deficit) causing an increase in prices of food articles and food products.

The RBI has also revised the inflation target from 5 per cent to 6.5 per cent. The inflation has increased from -0.12 per cent to 1.21 per cent within a span of six weeks, thus, reflecting a rise of more than 1 per cent. It has also kept the GDP target unchanged at 6 per cent with an upward bias.

The RBI has responded in a way so that its growth and inflationary targets are met well within their target limits as set and also bridge the fiscal gap by initiating the first phase of its exit from expansionary policy. It has ended the forex swap facility for banks and cut the export credit refinance facility to 15 per cent, the level seen in pre-crisis time from the current level of 50 per cent. It has also ended the special repurchase window for banks, mutual funds and NBFCs with immediate effect.

Following the announcements by RBI, the domestic markets have responded negatively. The barometer Sensex tanked 386 points on profit booking across all sectors except IT companies. The BSE realty index and metals were heavily battered slipping 6.24 per cent and 5.43 per cent respectively. On the debt front, the ten year G-Sec yield slipped from 7.41 per cent to 7.31 per cent, a gain of 0.1 per cent or 10 basis points.