RBI hints at keeping policy rates firm until inflationary pressures reduce
Jul 31, 2012

Author: PersonalFN Content & Research Team

RBI hints at keeping policy rates firm until inflationary pressures reduce

The deterioration in macro-economic conditions and synchronized global economic slowdown, leading to a loss in upward market momentum (as seen in early months of the year), refrained the Reserve Bank of India (RBI) from reducing policy rates despite a slump in domestic economic growth rate, and dismal industrial activity.

In the Euro zone, although the prospects of immediate default have been averted the situation is still construed to be worrisome. While the European Commission (EC) summit held on July 2, 2012 improved market confidence, it was only temporary. The interlinked sovereign debt stress in the Euro zone, still remains a source of most significant global systemic risk for the fiscal and financial stability. In fact in the recent weeks, renewed concerns about Greece and need for a collective support for Spain and Italy have amplified the risk, and elevated a chance of spill over to other Euro countries and rest of the world. In the last update of the World Economic Outlook (WEO) the International Monetary Fund (IMF) has thus revised its projections for global growth in 2012 marginally downward to 3.5%, and has emphasised further on downside risk to growth. U.K. (Euro’s third largest economy), recently reported shocking second quarter economic growth rate of -0.7%, attributed by fall in the construction sector and weakness in production and services sector. Likewise Germany too witnessed a downward revision in its economic outlook (by rating agencies Moody’s) from stable to negative.

As far as the U.S. economy is concerned, their second quarter GDP growth number too was quite a dismaying source of economic data as it expanded by mere 1.5%, according to the estimates (released by the Bureau of Economic Analysis, in July 2012), thus forming a descending trend for the last two quarters of the year 2012 and manifesting poor economic growth.

The persistent weakness in global economy has also reflected its bearing on the BRICS (Brazil, Russia, India, China and South Africa) economies, where most of them have experienced moderation in economic growth. For instance, growth in China fell from 8.1% in Q1 of 2012 to 7.6% in Q2. Likewise growth in Brazil and South Africa too, moderated significantly in Q1 of 2012.

Health of India's economy

(Source: CSO, PersonalFN Research)


As far as India is concerned as depicted by the chart above, GDP growth rate decelerated over the past four successive quarters. Significant slowdown in industrial growth as well as deceleration in services sector activity pulled down the overall GDP growth to 6.5% for 2011-12, below the Reserve Bank’s baseline projection of 7%. On the expenditure side, significant weakness in investment activity was the main cause of the slowdown.

Thus according to the IMF, growth in number of major Emerging and Developing Economies (EDEs) turned out to be lower than forecasted by it earlier.

The Inflation bug!

(Source: CSO, PersonalFN Research)


As far as inflation is concerned, inflationary pressures softened across advanced and emerging economies, reflecting both weaker growth prospects and moderation in commodity prices. Among the BRICS nations inflation fell significantly in China and Russia, while it eased for Brazil and South Africa. In India however, as revealed the chart above the Wholesale Price Index (WPI) inflation continued to be remain over the 7.0% mark despite a significant slowdown in economic growth. This stickiness in WPI inflation was largely on account of primary food inflation, which was in double-digits during Q1 of 2012-13 due to an unusual spike in vegetable prices and sustained high inflation in protein items. However, fuel inflation depicted signs of moderation (reduced from 12.1% in April 2012, to 11.5% in May and further to 10.3% in June 2012) as global crude oil prices cooled from their earlier highs. But now the reversal in declining trend in global crude oil in the recent weeks has a bearing on domestic inflationary pressures.

As far as the liquidity condition is concerned, it has eased i.e. improved significantly since the beginning of the fiscal year 2012, due persistent Open Market Operations (OMOs) (which had an impact of releasing nearly Rs 860 billion) and increase in limit of export credit refinance to 50% (from 15%); which had an equivalent impact of 50 bps reduction in CRR (thereby releasing liquidity to the tune of Rs 300 billion). The improvement in liquidity was also well reflected by the weighted average call money rate (which is the operating target of the Reserve Bank) as it stayed close to the policy repo rate.

Monetary Policy action:

Thus on the basis of an assessment of the aforementioned economic factors, it was decided to:

Keep the repo rate unchanged at 8.00%; and

Keep the reverse repo rate unchanged at 7.00%

Thereby, maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points.

Thus MSF rate determined with a spread of 100 basis points above the repo rate stands unchanged at 9.0%. Likewise the Bank Rate was also left untouched at 9.0% and Cash Reserve Ratio (CRR) too for banks at the last level of 4.75% of their Net Demand and Time Liabilities (NDTL) was left untouched.

However, in order to facilitate smooth flow of credit to productive sectors to support growth and Government’s disinvestment program, the Statutory Liquidity Ratio of scheduled commercial banks has been reduced by 100 basis points (bps) i.e. from 24% to 23%.

Policy rate tracker
Increase / (Decrease) in FY12-13 At present
Repo Rate (50 bps) 8.00%
Reverse Repo Rate (50 bps) 7.00%
Cash Reserve Ratio Unchanged 4.75%
Statutory Liquidity Ratio (100 bps) 23.00%
Bank Rate (50 bps) 9.00%

(Source: RBI, PersonalFN Research)


What does the policy stance mean and its impact?

The repo rate is the rate of interest charged by the central bank on borrowings by the commercial banks. Keeping it unchanged means, borrowing cost of commercial banks would remain unchanged. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may still remain stiff, as the commercial banks in the country would refrain from lending at cheaper rates, and this in turn may continue to put pressure on economic activity in the country.

Similarly, the interest rates on fixed deposits are expected to remain unchanged. At present 1-yr FDs (Fixed Deposits) are offering interest in the range of 7.25% - 9.25% p.a.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Keeping them unchanged will result in commercial banks fetching the same interest rate, as what they are receiving so far, for parking their surplus funds with RBI. The Cash Reserve Ratio is the amount of amount of liquid cash which the banks are supposed to maintain with RBI. Keeping it unchanged at the last reduced level of 4.75% may aid the present comfortable liquidity situation.

The Statutory Liquid Ratio (SLR) is the amount that the commercial banks require to maintain in the form of cash, or gold or govt. approved securities before providing credit to the customers. Reducing this will enable banks to provide flow of credit to productive sectors to support growth. It could also aid in Government’s disinvestment program.

Hence against this backdrop monetary policy action is intended to:

  • Contain inflation and anchor inflation expectations;
  • Support a sustainable growth path over the medium-term; and
  • Continue to provide liquidity to facilitate credit availability to productive sectors.
Domestic outlook and Projections:

GDP growth
Taking into account that monsoon is deficient and uneven thus far; there has been a slump in industrial activity and risk to domestic growth has intensified and there has been a greater integration of the Indian economy along with the global economy, which could have an adverse impact on growth – particularly industry and services sector, the economic growth projections for the fiscal year 2012-13 has been revised downwards to 6.5% (from 7.3% as set out in April 2012 policy).

WPI Inflation
Likewise, since thus far deficient and uneven monsoon continues to be a threat to food inflation. Also global crude oil prices are once again witnessing ascending movement, coupled with pass-through effect due to depreciation of the Indian rupee causing imported inflation, thus the projection for WPI inflation by March 2013 too has been revised upwards to 7.00% (from 6.5% as set out in April 2012 policy).

Guidance from monetary policy and path for interest rates:

The primary focus for the central bank now is controlling inflation in order to secure a sustainable path over the medium-term. While monetary actions over the past two years may have contributed to the growth slowdown – an unavoidable consequence – several other factors have played a significant role. Hence in the current circumstances, according to the central bank lowering policy rates will only aggravate inflationary impulses without necessarily stimulating growth. As the multiple constraints to growth are addressed, the Reserve Bank will stand ready to act appropriately.

At present while liquidity remains within the comfort zone of RBI, managing it further remains the objective of the central bank, and thus it will respond to liquidity pressures by way of OMOs.

In a turbulent global environment, the risks of external shocks are high and the RBI stands ready to respond to any such shocks swiftly, using all available instruments.

What should Debt fund investors do?

At present while taking exposure to debt mutual funds and fixed income instruments, one should clearly know their investment time horizon. Investors with an extreme short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 ½ months or liquid plus funds for next 3 to 6 months horizon. However, investors with a short to medium term investment horizon (of 1 to 2 years) may allocate a part of their investments to short-term income funds which should be held strictly with at least 1 year time horizon.

The present scenario also seems comfortable to look at longer horizon debt mutual funds. Thus, if you have a longer time horizon, then you can now hold some exposure to pure income funds. Since longer tenor papers will become attractive, longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has an investment horizon of say 2 to 3 years. However, one may witness some volatility in the near term as there is always an interest rate risk associated with longer maturity instruments.

Fixed Maturity Plans (FMPs) of upto 1 year may for some more time yield appealing returns and can also be considered as an option to bank FDs only if you are willing to hold it till maturity. You can consider investing your money in Fixed Deposits (FDs) as well, before the interest rates offered on them are reduced. At present 1 year FDs are offering interest in the range of 7.25% - 9.25% p.a.

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