Equity market reactions

The Indian equity markets, represented by SENSEX, have lost more than 7% or close to 1,200 points since January 15 amid high concern of rate hikes by central banks in India, China and the global uncertainty. The markets had more or less incorporated the effect of hike in CRR.  The policy declaration has eased the concern of the market and the SENSEX recovered from the day’s low of 15,982 to 16358 after the policy announcement.  We believe that it is a good time to enter the market as the index is at 16,300 levels and we expect SENSEX to touch 20,500 in 2010, which can get you about 25% returns.

Chart 1 shows the performance of SENSEX and five other sectoral indices since 31 December 2009 to 29 January 2010. All the six indices have declined in value. SENSEX has lost 6.3% Year-to-Date (YTD); however, the BSE FMCG index, BSE Power Index and BSE Bank index have lost lower in comparison to SENSEX. The BSE FMCG index has lost the least at 2.37%, whereas the BSE Real Estate index has lost the most at 9.2%.

Chart 1: Performance of BSE Indices from 31 December 2009 till 29 January 2010

Inflationary concerns

In the run-up to the monetary policy, RBI was under tremendous pressure to balance nascent growth of the economy and control the inflation levels. The WPI inflation for December 2009 (as of 15 January 2010) was unexpectedly high at 7.31%, which was much higher than the RBI’s projection of 6.5% for the FY10.

Also, the Consumer Price Index (CPI) – Industrial workers inflation for November 2009 was at 13.51%. Such high level of consumer price inflation was last seen in 1998. Generally in the past, there was not much gap in the level of WPI and CPI inflation, but since early 2009, the gap between the WPI and CPI inflation levels has increased tremendously and this gap is a cause of worry for the RBI. This can be seen in the Chart 2.

One of the key factors for the increase in gap between the indices is the rise in food prices on account of poor monsoon in 2009. The food inflation for the week ended 16 January 2010 is at 17.4%. Food articles have a 15% weightage in the WPI, whereas the weightage in the CPI (for Industrial Workers) is much higher at about 46%. We feel that food inflation would moderate from mid-2010 onwards, due to the higher base in the corresponding period a year back.

Typically, huge amount of liquidity in the system tends to put an upward pressure on inflation. A higher than normal outstanding reverse repo volume would indicate surplus liquidity in the banking system. As seen from chart 3, the reverse repo volumes are lower than their long-term average (indicated by the red line). Based on this information, we feel that excess liquidity is not the cause for the high levels of inflation.

The RBI feels that the high food inflation can lead to high levels of inflation in the other parts of the economy (source: Third quarter review of Macroeconomic and Monetary Developments for 2009-10). Based on this, the RBI has now raised the projection for WPI inflation to 8.5% from 6.5% in the previous quarter monetary review. However, the RBI expects the WPI inflation to moderate from July 2010, under the assumption of normal monsoon and global oil prices.

Chart 2: Emergence of gap in between the growth of two inflation

Credit growth

With over 98% of the net market borrowing program of the Central Government for FY10 already complete (as of 28 January 2010) and even with a CRR hike of 75 bps, there is enough liquidity in the system to cater to the needs of the borrowings by the commercial sector for remaining months of 2010.

Chart 4 shows that the aggregate deposit growth rate and commercial credit growth rate has fallen in 2009. Commercial credit growth rate has fallen at a much faster rate than the aggregate deposit growth rate. However, the RBI expects the aggregate deposits of scheduled commercial banks to grow by 17%. Due to lower credit outflow in 2009, RBI has revised the adjusted non-food credit growth projection for FY10 to 16% from 18% in the previous quarter monetary review.

Economic growth

In the first two quarters of FY10, the real GDP growth rate shot up from 6.1% in the first quarter to an unexpected 7.9% in the second quarter, driven by revival in industrial growth and services sector. The RBI expects the third quarter GDP growth rate to reflect the complete effect of failure in the summer crop due to deficient rainfall.

Even after assuming a near zero growth in agricultural production for FY10 and continued recovery in industrial production and services sector, the RBI has increased its forecast for GDP growth to 7.5% from 6.0% for FY10.

Chart 3: Reverse Repo Volumes

Key Risks

RBI has considered the following key risks that can make its forecast on GDP and inflation false:

• A downturn in global sentiment, not only affects our exports but also the domestic investments adversely
• If the global recovery turns out to be stronger than expected, then the oil prices may increase sharply and can stoke global inflationary pressures
• Expectations of low domestic inflation depends on lower food prices and if rainfall is inadequate in 2010, then the increase in food prices will continue to kindle inflation
• Economic growth and the persistence of excess liquidity in the system will continue to fuel inflationary expectations

Chart 4: Commercial Credit and Aggregate Deposits Growth Rates