Monetary Policy and Credit Policy

The Reserve Bank of India announced its second quarter review of monetary/credit 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.


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

projected inflation

  • 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.
  • 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:
  • 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
  • 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%
  • 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

Our Analysis:

It is quite evident from the mentioned facts in the credit policy 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.

Author: Rahul Sonthalia, Analyst, Kredent Group

Related posts:

  1. Will RBI retain easy monetary policy?
  2. First quarterly review of monetary policy 2010-11
  3. Annual Monetary policy 2010 – Highlights
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