By keeping the repo and the reverse repo rates unchanged and increasing the cash reserve ratio by 25 bps, RBI governor Y V Reddy has done what is right in the current situation—to control inflation he is drying up the excess liquidity from the system. A 25 bps CRR hike implies a mop out of about Rs 9000 cr liquidity from the system. Monetary policy is never useful to contain inflation arising out of supply side disruptions; fiscal policy measures are more appropriate tool. Under these circumstances, the governor did what is the best for the economy. He does not want to disrupt growth, but inflation control is his prime agenda.
Accordingly, the RBI is expecting an 8% to 8.5% GDP growth and targets inflation at 5.5%. Both look aggressive, but in line with his action of keeping a status quo on policy rates, he is sending a strong signal to the banking system not to increase the interest rate.
The governor has also emphasized on the quality of growth by directing banks to be more prudent and review exposures to sensitive sectors and off-balance sheet items. RBI has decreased risk weightage for housing loans between Rs 20 lakh and Rs30 lakh to 50%. This is a big positive for banks, as it would improve their capital adequacy ratio. Projecting a strong 16.5% to 17% expansion of M3 and a 20% non-food credit growth, the governor has indicated a strong economic growth for FY09, allaying fears in some section about an impending slowdown in the economy. RBI has also shown firm resolve to resort to open market operations to mop up dollars, thus signaling against an appreciation of currency going forward.
RBI has surprised the equity market, as the markets were expecting a hike in the policy rate. Despite a series of CRR hikes, liquidity is comfortable. This will drive the growth, although at a slower rate. Credit growth has moderated to 21%, which is in line with RBI’s target of 20%. However, credit-deposit ratio of banks would fall, as the CRR hike will leave less balances for banks to lend. This will lead to lower net interest income and spread, leading to lower profitability of banks over the medium term.
Deposit costs also remain at fairly high levels. We expect banks to roll back rate cuts that they had announced in the last quarter, easing some pressure on margins. Banks may also increase their lending rates to take care of spreads. We have seen that ICICI Bank has increased rates on auto loans and other private banks are planning to follow suit.
In summary, we feel that the monetary policy announcements will be cheered by the market. It is a prudent policy directive, which attempts to keep the economic growth momentum alive, but also keeps the global perspective in mind. With US rates likely to be cut in Wednesday’s Fed meeting, the RBI treaded the path of caution by not increasing the policy rate in India now— postponing the decision to a later date, , if the situation warrants.