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Macroeconomics Update

Credit Policy Analysis


27th October 27, 2009

The Reserve Bank of India announced its second quarter review of monetary policy. Despite the
fact that most of the key rates policy rates remained unchanged as expect, the benchmark indices
corrected by around 2% with the banking and real estate sectors plummeting the most. This is
mainly because of the fact that the policy sets a tone for the beginning of the reversal of Monetary
Easing.

Key Rates (%) Q1 FY10 Q2 FY10


Repo Rate 4.75 4.75
Reverse Repo Rate 3.25 3.25
CRR 5 5
SLR 24 25
Source: RBI

Some of the key highlights form the policy documents are:

• The share of agriculture in GDP has been declining over time, and as of 2008-09 it was 17.0 per cent.
However, experience shows that a deficient rainfall can have a disproportionate impact on overall
economic prospects and on the sense of well-being. Poor output will push up prices and depress rural
labor incomes. Given the inter-sectoral supply-demand linkages, the knock-on impact on the
industrial and services sectors can also be significant.
• Continuing the trend witnessed since Q2 of 2008-09, the two major components of demand, viz.,
private final consumption expenditure and gross fixed capital formation (with a combined weight of
around 88 per cent) decelerated further in Q1 of 2009-10. Government consumption, which had
increased sharply in Q3 and Q4 of 2008-09 due to the fiscal stimulus measures and the Sixth Pay
Commission payouts, also decelerated in Q1 of 2009-10. While the direct impact of fiscal stimulus is
waning, its indirect impact on private consumption and investment will persist for some more time
• The GDP projection for 2009-10 for policy purposes remains unaltered at 6%, made in the First Quarter
Review of July 2009.
• Keeping in view the global trend in commodity prices and the domestic demand-supply balance, the
baseline projection for WPI inflation at end-March 2010 is placed at 6.5 per cent with an upside bias. This
is higher than the 5.0 per cent WPI inflation projected in the First Quarter Review of July 2009 as the
upside risks have materialized
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Macroeconomics Update

Source: RBI

• The policy dilemma for India is different in some important respects from that of advanced
economies as also other emerging market economies. First, most of these countries do not face an
immediate risk of inflation. Indeed, in several advanced economies, the concerns were about a
possible deflation, which are just about waning. On the other hand, India is actively confronted
with an upturn in inflation – a rising WPI inflation and stubbornly elevated CPI inflation
• An issue of some immediate relevance is the critical need to downsize the government
borrowing programme so as to help sustain a moderate interest rate regime. This is crucial
for investment demand to pick up on which hinge our long-term economic prospects
• Reversing monetary policy easing stems from the concern about inflation. WPI inflation has
turned positive, the base effect which has kept WPI low so far is now gone and CPI inflation has
remained stubbornly elevated. On a financial year basis, WPI has already increased by 5.95 per
cent. In as much as monetary policy acts with a lag, there is need to act now
• The Reserve Bank’s inflation expectations survey shows that households expect inflation to
increase over the next three months as also one year. The lag with which monetary policy
operates suggests that there is a case for tightening sooner rather than late
• The balance of judgment at the current juncture is that it may be appropriate to sequence the
‘exit’ in a calibrated way so that while the recovery process is not hampered, inflation
expectations remain anchored.

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Macroeconomics Update

• The ‘exit’ process can begin with the closure of some special liquidity support measures. In this
policy government has indeed removed some special liquidity support measures like:

o The statutory liquidity ratio (SLR), which was reduced from 25 per cent of demand and time
liabilities to 24 per cent, is being restored to 25 per cent
o The limit for export credit refinance facility [(under section 17(3A) of the RBI Act], which was
raised to 50 per cent of eligible outstanding export credit, is being returned to the pre-crisis
level of 15%
o The two non-standard refinance facilities: (i) special refinance facility for scheduled
commercial banks under section 17(3B) of the RBI Act (available up to March 31, 2010),
and (ii) special term repo facility for scheduled commercial banks (for funding to MFs,
NBFCs, and HFCs) (available up to March 31, 2010) are being discontinued with immediate
effect

• In view of large increase in credit to the commercial real estate sector over the last one year and
the extent of restructured advances in this sector, it would be prudent to build cushion against likely
non-performing assets (NPAs). Accordingly, it is proposed that to increase the provisioning
requirement for advances to the commercial real estate sector classified as ‘standard
assets’ from the present level of 0.40 per cent to 1 per cent

Kredent Analysis:

It is quite evident from the mentioned facts that the central bank will in any circumstances curtain
the rise in inflation and on the basis of the overall assessment the first priority among the stance of
monetary policy for the remaining period of 2009-10 is to Keep a vigil on the trends in inflation and
be prepared to respond swiftly and effectively through policy adjustments to stabilize inflation
expectations.

Thus we strongly believe that a rate hike is definitely on the cards in third quarter monetary policy
for FY2009-10 and hence as already mentioned in the report titled “Credit Policy Eve” one should
start booking profits from the rate sensitive sectors like banking, real estate and infrastructure and
start moving towards defensive sectors.

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Macroeconomics Update

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