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Decoding the Credit Policy

Thursday 9 May 2013

By Dipen Shah, Sr. Vice President - Private Client Group Research, Kotak Securities

While the RBI did respond to the Government’s recent fiscal initiatives and reduced interest rates by 25bps at its recent policy meeting, it differed from the market on the continuing fall in inflation and reversal of growth rates in the future.

Markets have been discounting a continuing fall in inflation due to the fall in crude prices as well as the slowing industrial growth (reflected in core inflation coming down sharply to about 3.5%). On the other hand, the recent Government initiatives have raised hopes of a faster recovery in the growth rates.

However, the RBI has sounded caution on these issues. It has indicated that, while growth rate seems to have bottomed out, faster growth will come about only if the monetary measures are supplemented by efforts towards easing the supply bottlenecks, improving governance, stepping up public investment and continuing commitment to fiscal consolidation. As of now, the industrial and services growth remain impaired because of various bottlenecks and uncertain global environment.

RBI expects a moderate recovery in growth to 5.7% in 2013/14 from 5.0% in FY13. According to the RBI, the outlook for industrial activity remains "subdued". The pipeline of new investment projects is "drying up" and existing projects have been "stalled" due to bottlenecks and slow implementation. Also, global growth is "unlikely" to improve significantly in 2013/14, according to the RBI.

To that extent, the RBI wants the Government to remove the bottlenecks and promote investments in infrastructure.

On inflation also, the RBI has sounded out risk factors like sectoral demand supply imbalances, ongoing correction in administered prices and pressures stemming from MSP increases. Supply side constraints may feed inflationary pressures if sharp interest rate reversals stoke demand.

It expects inflation to be range-bound around 5.5% in 2013/14. The RBI will endeavor to bring down that rate to 5% March 2014 and to 3.0% over the medium term.

RBI is also concerned about the Current Account Deficit. While in FY13, CAD was financed by the excess liquidity in the global economy, the liquidity situation could quickly alter for developing markets including India. The RBI feels this can be due to changes in outlook for developed economies and also process shocks, which could result in capital outflows.

'Little space' for future cuts and possibility of rate reversals
RBI has also indicated that, based on the current growth rates, inflation and CAD situation, there is little space for further monetary easing. Also, the RBI has indicated that, the risks to CAD, which stem from sharp reversals of inflows, may call for reversal (increases) in interest rates. We opine these statements will result in anchoring inflationary expectations.

We also note that, the RBI has also indicated that, it will ease more aggressively if, the CAD moderates more than expected or if inflation cools off faster than anticipated.

We expect a further 50bp cut
We expect RBI to reduce rates further by 50 bps over the course of the year, contingent upon delivery on fiscal front by the government. Also, with the latest rate cut, policy rates are near pre-crisis level - we note that, pre-crisis period (2006-2008) witnessed an average CRR of 6.5%, while reverse repo and repo rates averaged at 6% and 7.5%. In fact, during last decade, 2001-2012, average policy repo rate was 7.3%. This indicates that, we have now entered in neutral interest rates (long-term average) band. From now on, significant diversion in policy rates would warrant significant change in economic scenario.

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