Third Quarter Monetary Policy Review

 The RBI today cut the CRR by 50 bps to 5.5% while keeping all other rates unchanged. The CRR cut will be effective the fortnight beginning 28th January 2012. Other highlights are as follows:

1. GDP growth projection for 2011 – 12 revised to 7% from 7.6% earlier
2. WPI inflation projection for March 2012 retained at 7%
3. M3 growth projection for 2011 – 12 retained at 15.5%
4. Non food credit growth projection revised to 16% from 18% earlier

Assessment
The RBI clearly acknowledges that downside risks to growth have increased and in particular seems worried about the slowdown in non food credit growth. On inflation, while the central bank notes the recent moderation; there are sufficient caveats as well including the stickiness in protein based food items and non-food manufactured products inflation. Moreover, there are still upside risks from global crude oil prices, impact of rupee depreciation, and slippage in fiscal deficit.

Very importantly, the central bank seems quite blunt in its assessment that ‘it is premature to begin reducing the policy rate’. The timing and magnitude of future rate actions is seen contingent on some factors outside the RBI’s purview namely initiatives to remove supply bottlenecks and signs of fiscal consolidation from the government. In that context, the Union Budget due March would be a key input for RBI when deciding future course of policy action.

Interpretation

We have been hopeful of a CRR cut although expectations had been diluted somewhat owing to recent comments from RBI officials With today’s action the RBI has shown more seriousness to defend its liquidity target of 1% of NDTL of banks (approximately INR 60,000 crores). However, the CRR alone will not be enough to achieve the target given that actual deficit is still likely to be upward of INR 1,00,000 crores even after the CRR cut. Market participants will keenly be watching whether the RBI continues with its OMO operations as well. If OMO support continues then the current range of government bonds may continue as well. However, if the RBI were to choose to shift focus entirely away from OMO it may lead to some pressure on government bonds and hence cause some incremental steepening of the curve in the near term.

At any rate we expect the curve to incrementally steepen from the start of the new financial year in April. Relatively better liquidity, expectations of rate cut from RBI, and falling credit to deposit ratios of banks should all contribute to fall in shorter end rates from April. Whereas with OMO programme unlikely to continue after March and market having to absorb a new borrowing calendar, longer end rates may fall more slowly. This should eventually cause a bullish steepening of the yield curve in the course of the financial year ahead.

Source : IDFC AMC