MONETARY POLICY REVIEW
(THIRD QUARTER) 2007-08
RBI: Stands tall like Rock of Gibraltar

[Edited View of a Brokerage House]

The RBI Governor, Dr YV Reddy presented the Third Quarter Review of Annual Statement on Monetary Policy for Year 2007-08, which was in line with the general expectations. By leaving all key policy rates unchanged, RBI has reinforced the emphasis on price stability and anchoring inflationary expectations along with a monetary and interest rate environment conducive for continuation of the growth momentum and orderly conditions in financial markets.
On the "Growth Vs Price stability" front, RBI is comfortable with the current moderation in growth process which has come along expected lines. Dr Reddy also said a few sectors, which have witnessed some sharp moderation, need a disaggregated analysis and require a host of policy matters (not only monetary policy!!). On the inflation front, he said although apparent inflation (read headline inflation) is under control, underlying inflation (read CPI) is still higher.
He further pointed out that the central bank needs to rebalance demand and supply forces in the economy. Investment in the economy is improving, which, in turn, would improve supply side forces, whereas the RBI would continue to keep a vigil on demand side forces to tame any unwarranted increase in inflationary expectations.
The policy paper further talked about the fact that the underlying fundamentals of the economy remain strong and resilient. However, there is a need for continued vigilance to take prompt, timely and appropriate measures to mitigate any kind of financial instability spreading to our boundaries from global developments.

Key highlights:

The reverse repo rate and repo rate under LAF have been kept unchanged at 6% and 7.75%, respectively.

• The bank rate has been kept unchanged at 6%.
• Cash reserve ratio (CRR) has been kept unchanged at 7.5%.
• Overall real GDP growth projection for 2007-08 has been retained at around 8.5%.
• Target is to contain inflation close to 5.0% in 2007-08 while conditioning expectations in the range of 4.0-4.5%.
• While non-food credit has decelerated, growth in money supply and aggregate deposits of scheduled commercial banks (SCBs) continue to expand well above indicative projections.
• High growth in reserve money is driven by large accretion to RBI's net foreign exchange assets.
• Liquidity management will assume priority in the conduct of monetary policy through appropriate and timely action.

The monetary policy stance of the central bank is neutral and less hawkish than earlier policy papers. RBI has left all key policy unchanged on the back of money supply crossing 23% with a jump in growth of reserve money as against the RBI's target of 17-17.5%, higher underlying inflation (measured by CPI) and to some extent elevated asset prices.

The biggest argument put forth in favor of a cut in the policy rate is the interest rate differential between the US Fed rate and the RBI repo rate, which has already moved to 425 bps. The market is further expecting a cut in the Fed rate, when the US Federal Reserve Open Market Committee meets on January 29-30 2008.
However, a cut of 25 or 50 bps will not materially change the interest rate differential. Apart from this, the recent cut in the Fed rate has come in different environment rather than the normal course of action. This does not warrant any kind of similar act by the RBI, as domestic economy is not reeling under similar kind of problem.
The risk aversion by foreign investors may not lead to too much inflow of capital into emerging markets including India. We have already witnessed FII liquidation and their balance sheet unwinding (They have sold around Rs.115 bn in this month till January 25). Apart from this, foreign money does not chase Indian debt paper. In fact, equity attract majority of FII inflows.
RBI has largely restricted the inflow of foreign capital through the ECB window. However, going forward, RBI will not refrain from using the MSS window or hike in CRR for liquidity management in the economy.
After the announcement, the market reacted negatively and many banking stocks closed in the red. However, it is widely believed that the interest rate cycle has peaked in India.
Interest rates will start moving southwards from the next quarters (when the slack season starts). The demand and supply will decide the future interest rate (price for money). As deposit mobilization of banks is far ahead of the credit off-take, there will be downward movement of interest rate on both deposit as well as lending side.

Deposit and advances growth:

Even the RBI has referred to this in one of the paragraphs of the policy document. But this is a kind of veiled moral suasion (A persuasion tactic used by a central bank to influence and pressure, but not force, banks into adhering to a policy) by the RBI to signal the direction of interest rates in the banking system.
So, it is believed that the southward movement of interest rate will be positive for the rate sensitive sectors.