First Quarter Review of Monetary Policy - 2010-11

July 27, 2010

The monetary policy was presented in the backdrop of inflation remaining elevated above 10%
since February 2010 and a strengthening growth scenario. A lot of concerns were being raised
about RBI being behind the curve in containing inflation. The RBI responded by raising Reverse
Repo by 50 basis points and the Repo rate by 25 basis points, thus reducing the corridor
between Repo and Reverse Repo from 150 basis points to 125 basis points. A higher increase
in Reverse Repo indicated concern on inflation and a relatively lower increase in Repo rate
shows RBI’s commitment towards maintaining growth momentum. The biggest challenge
facing RBI is to ensure timely transmission of monetary policy towards containing inflationary
expectation. While normal monsoon will support food inflation and slow global growth in rest
of CY2010 will moderate energy and commodity price inflation, the issue in manufacturing
growth inflation still remains. A faster creation of capacity, removal of infrastructure bottlenecks
and improving productivity are not in the domain of the RBI.

The RBI has tried to tackle inflationary expectation with a two pronged approach of increasing
rates and shifting stance on liquidity from “Adequate Liquidity” to “Effective Liquidity”. Clearly
RBI wants to keep liquidity tighter than necessary so that rate hike signal gets transmitted to
contain inflation. Announcement of mid-quarterly review of policy is positive from market
communication point of view and in line with global practice.

RBI has always been walking a tightrope of managing conflicting interests of growth and
inflation. The policy once again has enforced that RBI will do the requisite to address both. As
of today inflation is a bigger concern and so the focus is on inflation. Tomorrow if growth
becomes a concern RBI will be back on the driver seat for nurturing growth.

Against this backdrop, the Reserve Bank through its monetary policy intends to:
• Contain inflation and anchor inflationary expectations, while being prepared to respond to
any further build-up of inflationary pressures.
• Maintain an interest rate regime consistent with price, output and financial stability.
• Actively manage liquidity to ensure that it remains broadly in balance so that excess
liquidity does not dilute the effectiveness of policy rate actions.

Outlook: Markets can expect marginally rising interest rates on the medium to long end of the
curve. The short term rates are expected to get partially supported by the narrowed corridor
and RBI’s ability to effectively manage liquidity. Lumpy government spending will pose a bigger
challenge to RBI in effective liquidity management. From an equity market point of view, the
rate sensitive sectors will probably come under some pressure for the short term but will take
solace from the fact that RBI is anchoring inflationary expectations.
The short term interest rates are near their 12 month high as liquidity is running short by Rs.550
bn.* in the banking system due to 3G outflows. We expect liquidity infusion of Rs.500 bn.* due
to Government spending in August and September, Rs.130 bn.* due to Abbott - Piramal deal,
Rs.200 bn.* due to RBI dividend, Rs.140 bn.* due to oil subsidy payment and Rs.100 bn.* due
to drop in currency circulation between now and mid Sept.'10. This is expected to normalize
prevailing tight liquidity which may bring down short term interest rates. Short term rates
currently provide an attractive opportunity to lock in.

* approximate internal estimates. Source: Prepared on the basis of RBI first quarter monetary
policy review.
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