India Focus

Treasury Economic Research

April 21, 2009

FY10 Annual Monetary Policy Review

• RBI cuts the repo and reverse repo rate by 25 bps to 4.75% and 3.25% respectively.
• Announces GDP growth forecast of 6% for FY10 and WPI inflation target of 4% for end
March-2010.
• Cautions against viewing possible negative WPI readings in 1H2009 as characteristic of
either deflation or significant demand destruction.
• Discusses role of sub-prime lending and provides estimate of effective lending rate.
• Emphasizes need to factor in liquidity support (OMO and MSS unwinding) in gauging
impact of government borrowings.
• Continues to emphasize risks to growth from both global and domestic factors.

While the majority of market participants were prepared for status quo, the RBI went in
for a token cut in policy rates of 25 bps. While this might not make a material difference to
lending or deposit rates, the signaling effect is important. The RBI continues to be
concerned about growth prospects (and less worried about inflation than even in the
January policy) and sees enough growth risks around the corner not to take its feet off the
monetary pedals.

Table 1: FY10 projections (% yoy)

RBI FY10 HDFC Bank
Variable Current projections forecast
GDP growth * 7.1 6.0 5.8
WPI Inflation 0.2 4.0 3.7
M3 18.6 17.0 17.0
Non-food credit growth 17.5 20.0 18.0
Deposit growth 19.8 18.0 17.0
Source: RBI & HDFC Bank
Note:* FY09 CSO Advance estimates

However the fact that it cut rates by a quarter of a percentage point instead of the half that
had become the norm over the past few months suggests that India’s policy rate
configuration is close to a bottom. Specifically, we forecast average WPI inflation for FY10
to be around 2-2.5% and that should imply a floor of 2.5-3 per cent for the reverse repo
rate. Thus for the rest of 2009 we see at the most two or three rate cuts of 25 bps each. Our
sense is that we are returning to the more normal practice of announcing policy measures
in the quarterly statements. It is quite likely that the reduction in rates would be
announced in the next few policies rather than as interim moves responding to adverse
events.
We have in the past emphasized the fact that managing the government borrowing
programme remains the key challenge for the central bank in 2009-10 given the whopping
borrowings that has come on the back of fiscal expansion. While there are no new
initiatives from the RBI on this front, it does set the record straight by clearly enunciating
the measures that it has already taken and the impact it has on the market.

The central bank has specified that it remains committed to ensuring that the government-
borrowing programme is conducted in a manner that is non-disruptive to the fixed
income market. Citing a buffer of close to Rs 1,20,000 crores likely to be provided by it
through auction-based OMOs and MSS unwinding, the monetary authority has
specifically drawn attention to the fact that borrowings net of this cushion are slated to be
just around Rs 85,364 cr i.e much lower than the Rs 2,07,364 cr aggregate net borrowing
figure targeted for H1FY10. Its accommodation of the government-borrowing programme
is likely to be close to a 3% reduction in the CRR. We believe that conditions are ripe for a
rally in government bonds and see a move in the 10-year yields to the 6 per cent level.
However, we would recommend caution at levels below 6 per cent. There are risks around
the corner, particularly those related to the yet unknown contours of the borrowing
programme that will come with the new budget due sometime in June,2009.

Table 2:Central government borrowings: 1HFY10

(Amt. in Rs crores) FY08 FY09 FY10
Gross market borrowings 97,000 1,06,000 2,41,000
Less: Repayments 30,554 44,028 33,636
Net market borrowings 66,446 61,972 2,07,364
Less: OMO purchases 0 0 80,000
Less: MSS Unwinding 0 0 42,000
Add: MSS Issuances (net)* 69,077 5,263 0
Net supply of fresh securities 135,523 67,235 85,364
*Includes dated securities and Treasury bills
Source: RBI

Fig. 1: Bond yields ease on rate cut move

Domestic 10 year sovereign bond yield

9
8.5
8
7.5
(%)

7
6.5
6
5.5
5
10/1/2008

11/1/2008

12/1/2008

1/1/2009

2/1/2009

3/1/2009

4/1/2009

Source: Reuters & HDFC Bank

We were surprised and pleased with the extensive discussion on sub-prime lending
rates as we were with the reasons for the stickiness of lending rates that the RBI has
provided. The central bank has identified the block created by firm administered interest
rates on small savings as an important factor behind keeping deposit rates high amidst
aggressive monetary easing. Other reasons such as locking into high cost fixed rate
deposits (in the wake of the financial crisis in October 2008) and competition for wholesale
deposits during the credit boom of the last three years have also been cited as reasons for
inflexible lending rates. Rigidities that link BPLRs of banks to concessional lending rates
on agriculture and exports have been additionally highlighted as a reason for sticky
lending rates.

Taking note of the fact that close to 75% of bank lending in recent months has been done at
sub-prime rates, the RBI has compiled effective lending rates that point towards a distinct
moderation. After climbing to 12.3% in 2007-08, effective lending rates are likely to have
eased below 10.9% by the end of FY09. Nevertheless, the monetary authority has specified
that the degree of decline in effective lending rates continues to lag behind key policy rate
cuts. However, given the current policy rate configuration, receding inflationary
pressures, slower credit growth and some normalization in bank cost of funds as high cost
deposits locked into last year run off, we believe that lending rates are likely to decline by
around 100 bps during the next three months and align more closely with policy rates.
Treasury economics research team

Abheek Barua,
Chief economist
Phone number: +91 (0) 124-4664327
Email ID: abheek.barua@hdfcbank.com

Shivom Chakravarti,
Economist
Phone number: +91 (0) 124-4664356
Email ID: shivom.chakravarti@hdfcbank.com

Jyotinder Kaur,
Economist
Phone number: +91 (0) 124-4664338
Email ID: jyotinder.kaur@hdfcbank.com

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