1. INDIAN ECONOMY: RBI RAISES POLICY RATES TO CONTROL INFLATION; WILL REVIEW POLICY TWICE A QUARTER

THE MEASURES
- Increase in the Repo rate by 25bps to 5.75% as per expectations.
- Increase in the Reverse Repo rate by 50 bps to 4.50% vs expectations of a 25bps hike.
- CRR has been left unchanged as expected.
- The FY11 GDP growth estimate has been enhanced by 50 bps to 8.5% (from 8% with an upward bias as per April Policy) as per expectations.
- Similarly the March 2011 inflation estimate has been enhanced by 50 bps to 6.0% (from 5.5% as per April Policy) as per expectations.
- No extension granted to the daily second LAF facility as per expectations.
- Monetary stance is substantially altered to give ascendancy of inflation control in policy priority as per expectations.
- Although RBI has taken mid-course corrective actions in the past and retains the right to do so even now, somewhat unexpectedly, the RBI has increased the frequency of review of its policy to one and half months from a quarter at present.
RBI RAISED SHORT TERM LIQUIDITY MANAGEMENT RATES - BROADLY IN LINE WITH EXPECTATIONS – MILD SURPRISE ON REVERSE REPO
RBI NOTED THAT THE MARKET MOVING IN THE REPO MODE ACTED AS ANAUTONOMOUS TIGHTENING OF MONETARY CONDITIONS BY 150 BASIS POINTS


RBI’S ASSESSMENT AND EXPLANATION
- Global growth and inflation has been multi speed. Visible soft spots in Europe and the US contrasts with relatively rapid recovery in EMEs accompanied by faster growth in prices. Global growth in the second half of 2010 will be lower than that in the first half. Global inflationary pressures are expected to be subdued over the next few months.
- On the domestic front, the recovery has consolidated and is becoming increasingly broad-based. The strength of the recovery is also reflected in the sales and profitability growth of the corporate sector. Besides replenishment of inventories, investment intentions are being translated into action across sectors, particularly in power, telecom and metals. However, if the global recovery slows down, it will affect all EMEs, including India, through the usual exports, financing and confidence channels.
- The recent partial deregulation and increase in administered prices of petroleum products is welcome from long-term fiscal consolidation and energy conservation perspective. Nevertheless, it will have an inflationary impact in the short term of 1% immediate impact followed by second round impacts in coming months.
- Food price inflation has remained at an elevated level for over a year now, reflecting structural bottlenecks in certain commodities such as pulses, milk and vegetables. The Reserve Bank’s quarterly inflation expectation survey conducted during the first fortnight of June 2010 indicates that short-term inflationary expectations have increased marginally.
- Notwithstanding the current inflation scenario, it is important to recognise that in the last decade (2000-01 to 2009-10), the average inflation rate, measured both in terms of WPI and CPI, moderated to around 5 per cent from the historical trend rate of about 7.5%. Against this backdrop, the conduct of monetary policy will continue to condition and contain perception of inflation in the range of 4.0-4.5%. This will be in line with the medium-term objective of 3.0% inflation consistent with India’s broader integration into the global economy.
- The main risk of RBI’s assessment emanates from the global scenario and has two key dimensions. First if the global recovery falters, the risk of which has increased since the April 2010 policy announcement, the performance of EMEs is likely to be adversely affected. The more significant risk, though, is from a potential slowdown in capital inflows. India’s rapid recovery has resulted in a widening of the current account deficit, as imports have grown faster than exports. Apart from narrowing the comfortable buffer between the current account deficit and net capital inflows, this may constrain domestic investment, which is critical to achieving and sustaining high growth rates.
- Current market conditions indicate that while liquidity pressures will ease, the system is likely to remain in deficit mode for now.
- There is no unique way to determine the appropriate width of the policy interest rate corridor. But the guiding principles are: (i) it should be broad enough not to unduly incentivise market participants to place their surplus funds with the central bank; (ii) it should not be so broad that it gives scope for greater interest rate volatility to distort the policy signal.
- Rough estimates show an improvement in the total flow of financial resources from banks, non-banks and external sources to the commercial sector during 1QFY11 (to Rs2,500 bn as against Rs610 bn during 1QFY10). Disaggregated data suggest that credit growth to all major sectors such as agriculture, industry, services and personal loans had begun to improve from November 2009 onwards.
- The 10-year benchmark government security fell to 7.59% in June 2010 from 8.01 per cent in April 2010 in the expectation that the Government will reduce market borrowing because of higher realisations from spectrum auctions. Subsequently, the yield moved up to 7.73% by the third week of July 2010. Of the budgeted net market borrowing of the Central Government for FY11 at Rs.3,450 bn, about 38.5% (Rs.1,329 bn) of the borrowing was completed by mid-July 2010.
- The foreign exchange market saw volatility increase relative to the previous quarter, with the rupee showing two-way movements in the range of Rs.44.33-Rs.47.57 per US dollar. During 1QFY11, both the nominal and real effective exchange rates (NEER and REER) have appreciated.


TAKEAWAYS FROM THE POLICY MEASURE AND RBI’S ASSESSMENT
- With the policy rate hikes, change in stance and the outline of liquidity conditions, the RBI has done its bit for inflation control. Importantly, RBI has reiterated its resolve to contain inflation perception in the range of 4.0-4.5% and the medium-term objective of 3% inflation set out earlier conducive to India’s integration with the global economy. The strong stance is important in view of the July inflation quoted (press reports) at 11% (as against our estimate of 10.2%) by India’s Chief Statistician Mr. T.C.A. Anant. RBI’s move is therefore imperative and is expected to anchor inflationary expectations at the margin.
- The reduction of the LAF corridor from 150 bps to 125 bps is attempted as an additional measure to contain volatility of short term rates and push the minimum rates up. The market being in repo mode and expected to be so for some time makes the measure more of a signal of anti inflationary resolve of RBI. The instrument, however, would become functional when the system returns to excess liquidity again or for those institutions that turns liquid faster than others.

RBI’s MEASURE IS TIMELY IN VIEW OF EXPECTED DOUBLE DIGIT INFLATION IN JULY


- The change in monetary stance of RBI is instructive. While interest rate regime has gained ascendancy in policy priority in lieu of liquidity management, short-term liquidity management would be in focus in place of ensuring adequate provision of liquidity for credit growth. In our view this is indicative of the shift in focus from short-term liquidity situation (which would continue to be actively managed) to long-term liquidity situation which might become stressful going forward.
CHANGES IN POLICY STANCE OF RBI – INTEREST RATE REGIME AND LIQUIDITY MANAGEMENT ALTERS POSITION, LIQUIDITY OBJECTIVE CHANGED MATERIALLY

Stance as per July 27 Policy	Stance as per April 20 Policy
Contain inflation and anchor inflationary expectations, while being prepared to respond to any further build-up of inflationary pressures.	Anchor inflation expectations, while being prepared to respond appropriately, swiftly and effectively to further build-up of inflationary pressures.
Maintain an interest rate regime consistent with price, output and financial stability.	Actively manage liquidity to ensure that the growth in demand for credit by both the private and public sectors is satisfied in a non-disruptive way.
Actively manage liquidity to ensure that it remains broadly in balance so that excess liquidity does not dilute the effectiveness of policy rate actions.	Maintain an interest rate regime consistent with price, output and financial stability.

- The combined impact on liquidity is therefore, much complicated. Short term rates have remained elevated for longer time than expected as the Government spending is being more staggered than expected. Although there has been some softening of money market rates in the past couple of days coupled with a lower recourse to RBI’s repo window (~Rs400bn against Rs600-700bn), this is yet to establish as a trend. Moreover, Central Government’s cash balances with RBI that has come down to Rs550bn from Rs700-800bn at end-June/early July matches with the recourse to repo window of RBI. Thus while liquidity situation may improve by August (possibly prompting RBI not to extend the second LAF facility), it is clear the system as a whole is not operating with any liquidity buffer.

THE FOCUS ON SHORT TERM LIQUIDTY MANAGEMENT TO CONTINUE


THERE HAS BEEN SOME MODERATION IN SHORT-TERM RATES RECENTLY ALTHOUGH YET TO ESTABLISH ITSELF AS A TREND


- It is likely that with the introduction of base rate, there would be greater competition among banks to lend acting as a barrier to push deposit rates down, lest it affects banks’ margin. A more likely scenario, however, is that the rapid expansion of credit market leaves banks’ with pricing power that can be used to increase deposit rates, albeit with a lag. The parallel initiative of financial inclusion (very significantly, RBI has allowed mobile banking now) may alleviate the banks’ liability constraints in the medium term.
- While capital flows so far has held up and the promise of near zero policy rates abroad for extended period of time indeed makes relative attractiveness of Indian growth a compelling proposition for capital inflow – evidently this would be volatile and partly would go to fund the higher current account deficit, itself a result of strong growth and import of capital goods.
- However, if none of the above holds, RBI would need to inject enduring liquidity through open market operation (OMO) to fund private credit growth – similar in the nature of liquidity infusion to fund heavy Government borrowing of FY10.
- Evidently, the contradiction of raising rates with continued liquidity support which may transform from repo balance to OMO for RBI provides a challenging outlook to monetary policy management till inflation abates on brighter prospect of monsoon, agriculture, international oil and metal prices, etc.

THE LIQUIDITY SITUATION TO EVEN OUT BETWEEN SURPLUS RISING CREDIT GROWTH CALLS FOR HIGHER DEPOSIT GROWTH GOVERNMENT AND DEFICIT BANKS AND PRIVATE SECTOR

RISING CREDIT GROWTH CALLS FOR HIGHER DEPOSIT GROWTH OR OMO FROM RBI OR HIGHER CAPITAL FLOWS FROM ABROAD                          


- Other things remaining same we expect continued rate hike upto 50 bps more during FY11 (raised from our earlier expectation of only 25 bps more) in view of the indication of further firming up of inflation in July.
- We continue to hold that softening of inflationary outlook in H2FY11 and reduced Government borrowing programme for H2FY11 would mitigate the market determined short term rates as the Government vacates the credit market for private sector growth. However, if capital flows aren’t adequate, the pressure on liquidity may permeate from longer term and would continue to ebb policy rates higher apart from RBI’s own push to control inflation. We still do not foresee policy rates meaningfully leading market rates to signal anti-inflationary stance. To that extent RBI has not forsaken the growth supportive stance altogether.
2. MONSOON UPDATE: Cumulative rainfall deficiency improves again to 5% on July 27: Outlook positive
- Overall rainfall deficiency in the country as a whole improved to 5% for the period June 1 to July 27.
- While temporal pattern of rainfall is improving rapidly, the spatial pattern shows that except the East & North-East, all other regions have recorded sharp improvement in rainfall recently.
- According to forecast by IMD, heavy rainfall activity would continue various parts of the country but concentrated on the west coast, western region and the northern-Himalayan region. The extended forecast up to August 1 predicts increased rainfall activity over central and north Peninsular India.
- The International Research Institute (IRI) for Climate and Society saw the possibility of heavy to very heavy rains in West and Northwest India. Thus more rains are expected for Gujarat, Rajasthan and Konkan even as south interior peninsula appears to have entered a phase of relative calm.
- According to the Japanese researchers (Japan Agency for Marine-Earth Science and Technology - Jamstec) a monsoon-friendly La Nina condition has been established rather quickly in the east equatorial Pacific Ocean in June itself.

RAINFALL UPTO JULY 27, 2010 (CUMULATIVE SINCE JUNE 1, 2010)
	Actual rainfall (mm)	% Departure from LPA
Country as a whole	396.2	-5%
North-West India	248.7	-3%
Central India	448.7	-1%
South Peninsula	391.7	11%
East and North-East India	575.3	-22%
Category	No. of Subdivisions	Range (% Dep from LPA)
Excess	8	21% to 80%
Normal	20	19% to -18%
Deficient	8	-20% to -45%
Scanty	0	-
Total Subdivisions	36	80% to -45%

PROGRESS OF MONSOON IN RECENT PERIOD (CUMULATIVE SINCE JUNE 1, 2010)
Category	18-Jul	19-Jul	20-Jul	21-Jul	22-Jul	23-Jul	24-Jul	25-Jul	26-Jul	27-Jul
Excess	5	4	4	5	7	9	10	9	8	8
Normal	18	18	20	21	19	17	16	18	21	20
Deficient	13	14	12	10	10	10	10	9	7	8
Scanty	0	0	0	0	0	0	0	0	0	0
Departure from LPA	-16%	-16%	-15%	-14%	-12%	-11%	-11%	-9%	-7%	-5%
Dispersion in LPA	83% to -56%	81% to -50%	82% to -50%	79% to -51%	80% to -51%	77% to -52%	71% to -51%	67% to -51%	64% to -47%	80% to -45%

HEAVY RAINFALL OFF LATE IS REDUCING THE CUMULATIVE DEFICIT OF THE SEASON

SHARP IMPROVEMENT IN RAINFALL IN NORTH-WEST AND CENTRAL REGIONS IS PULLING THE ALL-INDIA AVERAGE UP