RBI Monetary Policy At A Glance

In its monetary policy meeting today, the Reserve Bank of India (RBI) held the repo rate steady at 8% -- as was widely expected. The central bank reiterated its resolve to bring down and sustain CPI inflation below 8% by January 2015 and further to 6% by January 2016. The RBI said if the economy stays on course, further policy tightening will not be warranted and faster-than anticipated disinflation will provide room for easing.

Headline inflation increased to 8.6% in April after recording a decline in the first two months of the year (Chart 1). Core CPI inflation has edged down slightly, but remains high at around 8%. It is yet to feel the full impact of interest-rate hikes undertaken by the RBI between September 2013 and January 2014. Recent upward movement in headline inflation was due to higher vegetable & fruits

prices (Chart 2) on the back of weather related disturbances and may prove to be transitory. In the coming months, a strong base effect of high inflation during June-November 2013 could soften CPI inflation. The big worry is the enhanced possibility of a recurrence in the El Nino this year, which could lead to weaker-than-normal monsoon, cranking up food inflation. Given the uncertainties, the RBI’s decision to hold interest rates steady is appropriate.

Monsoon is an uncontrollable risk but my understanding  shows that food inflation spikes even in normal-monsoon years. I understand that there is more to food inflation than supply struggling to catch up with demand. Farm growth has improved in recent years, yet food inflation has shot up. This is clearly because of inefficiencies in the farm-to-fork ecosystem and wastage of food items – specifically, food grains, fruits and vegetables. The primary mission for the new government therefore is to improve the supply chain and reduce wastage, pilferage and develop efficient agricultural markets, as discussed in our report.

The second factor that will give cues for future monetary policy decisions is fiscal discipline. The forthcoming Union Budget will be a litmus test on this count. Swift action by the government to tame food inflation and commitment to fiscal discipline will provide the RBI the elbow room for a pro-growth monetary stance.

Controlling food inflation, and hence headline inflation, is even more pertinent as the revival in growth -- in this fiscal and the next -- can limit the moderation in core inflation. The RBI maintains its baseline projection of GDP growth in FY15 at 5.5%. We expect growth to be higher this fiscal at 6% compared with 4.7% in FY14, led by a turnaround in industry.

In an effort to provide more room to banks to finance higher investment demand as the economy recovers, the RBI reduced the statutory liquidity ratio by 50bps to 22.5% of net demand and time liabilities. Also, it reduced the liquidity provided under the export credit refinance facility from 50% of eligible export credit outstanding to 32% in Tuesday’s meeting.

Credit growth expected to improve in 2014-15

 Aggregate Credit growth rate slowedto 13.3% y-o-y as on May 16, 2014 from 14.7 per cent as on May 17, 2013, due to sluggish investment demand and increased risk aversion given the deterioration in public-sector banks’ (PSBs’) asset quality

 Advances for Scheduled commercial banks (SCBs) grew by 14.8 per cent y-o-y in 2013-14. However, growth for small and mid-size PSBs was only ~10 per cent due to lower capital adequacy ratio and asset quality issues.

 We expect credit growth in the banking sector to improve to 16-18 per cent in 2014-15, especially in the second half given the decisive mandate at the elections.

Deposit growth to accelerate to 15-16 per cent in 2014-15

 Growth in bank deposits accelerated to 14.2 per cent y-o-y, as of May 16, 2014, from 13.5 per cent as of May 17, 2013. This increase can be attributed to a surge in the foreign currency non-resident (FCNR) deposits. Banks garnered almost $26 billion (Rs 1.5 – 1.7 trillion) in September – November 2013, under FCNR deposits.

 Bank deposits are forecast to grow at around 15-16 per cent in 2014-15, a tad higher than that in 2013-14. With expected moderation in CPI inflation, real returns on deposits will turn positive

Asset quality challenges to peak in 2014-15

 Gross Non performing asset (GNPA) stood at 3.8 - 4.0 % levels by March 2014. We expect moderation in slippages and sale to ARCs to contain NPA levels at ~4%.  The asset quality of PSBs continued to be under pressure, with gross non-performing assets (GNPAs) at 4.26 per cent

of advances (as of March 2014)- an increase of 59 bps on y-o-y basis. The asset quality of private sector banks, on the other hand, remained relatively robust, with GNPAs at 1.73 per cent of advances.

 We expect weak assets (Reported GNPA + 30% of outstanding restructured advances (excluding state power utilities) +75% of investments in security receipts) in the system to stabilize at ~ 5.7% by March 2015, after witnessing a sharp increase to 5.6% in March 2014 from 4.3% in March 2013.