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RBI hikes policy rates for the sixth time in 2010, may pause in December
November 4, 2010

The Reserve Bank of India announced the monetary policy review for second quarter of FY2011, in which it hiked the Repo rate and Reverse Repo rates by 25 bps.


Author : Manjunath Gaddi



Untitled Document

Highlights of RBI Monetary Policy Review for SECOND quarter of the financial year 2010-11

  • Repo rate increased by 25 basis points (bps) from 6.00% to 6.25% with immediate effect
  • Reverse repo rate increased by 25 bps from 5.00% to 5.25% with immediate effect
  • Cash Reserve Ratio (CRR) of Scheduled Banks has been retained at 6.0% of their net demand and time liabilities (NDTL)
  • Bank rate has been retained at 6.0%
  • Statutory Liquidity Ratio (SLR) rate has been retained at 25%
  • The baseline projection of Wholesale Price Index  (WPI) inflation for March 2011 has been reduced from 6.0% to 5.5% on account of base year change in WPI from 1993-94 to 2004-05
  • The baseline projection of real GDP growth for 2010-11, has been retained at 8.5%
  • As of early October, the non-food credit growth at 20.1% is close to the indicative projection of 20.0%
  • As of early October, the Year-on-Year (Y-o-Y) growth of money supply (M3) is at 15.20%, below the indicative projection of 17.0%
  • Housing loans to weigh heavier on the bank loan portfolios

The Reserve Bank of India (RBI) chose not to include any surprises in the second quarter monetary policy review for the Financial Year (FY) 2011. The RBI has decided to increase both the repo and reverse repo rate by 25 basis points (bps) to 6.25% and 5.25% respectively with immediate effect. The Bank rate and the Cash Reserve Ratio (CRR) are unchanged at 6.0%. The hike in the policy rates were along market expectations and both, the debt and equity markets had priced in this expectations. Chart 1 shows the hike in policy rates in 2010.

Persistent food inflation - a bigger cause of worry

Although the current level of inflation is still above the comfort zone of the RBI, the central bank has observed that the Wholesale Price Index (WPI) inflation and the non-food manufacturing inflation have moderated in the recent months. However, the food inflation has not moderated as expected despite good monsoon. The RBI has observed that the level of food inflation has been on the higher side for over a year now due to the changes in the food consumption patterns especially, increase in demand for protein based food items and the demand-supply mismatch in several food commodities. Although, the RBI has identified that the food inflation has become more structural in nature, it has not been able to find a solution to reduce the persistent high level of food inflation. At the best, the rate hikes can restrict the rise in prices that is caused by ripple effects of persistent high level of food inflation.


Chart 1: Policy Rate Hikes in 2010


The structural nature of the food inflation is caused mostly by changing food consumption patterns of Indians, where in Indians are increasingly consuming a high protein diet consisting of pulses, milk, eggs, fish and meat. Although, the protein based food items have a weight of 6.4% in the WPI, the level of inflation is very high in such items. The inflation for protein based food items peaked in May 2010 at 34% and in September 2010, it was still high at 23.9%

The 6.0% WPI inflation target for March 2011 was set when the base year of WPI was 1993-94. Due to the change in the base year of WPI from 1993-94 to 2004-05, the RBI has revised its inflation target for March 2011 to 5.5% from 6.0%.

Policy action: Higher margins from the borrower, higher provisioning by banks for housing loans

  1. There was no regulatory ceiling on the loan to value (LTV) ratio. This meant that the banks earlier could have financed 100% of the value of the house, but the banks used to lend only up to 85% to 90% of the house value. However, in this monetary policy review, the RBI has decided that the banks can lend only up to 80% of the house value. This step will force the borrower to arrange for the margin money of 20% on his own. The RBI has taken this step to prevent excessive leveraging by borrowers.

  2.  At present, for the housing loans with -
    • LTV up to 75% and for loans up to Rs. 30 lakhs, the risk weight is 50%
    • Loans over 30 lakhs with LTV up to 75%,the risk weight is 75%
    • LTV ratio more than 75 %, the risk weight of all housing loans, irrespective of the amount of loan, is 100%.
    In this policy review, the RBI has decided that the risk weight will be 125% for all housing loans over Rs. 75 lacs irrespective of LTV.

  3.  With the view that certain banks are offering teaser rate housing loans wherein, the loans are offered at lower interest rates in the first few years after which the loan rates become higher, RBI has proposed to “increase the standard asset provisioning by commercial banks for all such loans to 2%”

Except for the first step, all the other two steps taken by RBI on housing loans may not have direct impact on the borrower.  The other two steps are taken with the view to discourage banks to lend housing loans over Rs. 75 lakhs. Also, this move would ensure higher provisioning in the bank books for teaser rate home loans to take care of default by the borrowers when the interest rates increase after the first few years. The banks would have to decide whether to pass the burden on the borrowers but, considering the increased margin requirements, the banks may not pass on the extra burden to the borrowers.

Cause and Effect

Interest rate sensitive sectors like Automobiles, Real Estate and higher risk lending sectors like Aviation, Infrastructure and Capital Goods might face the heat as banks have already started to increase both lending and deposit rates.

On the other hand, the depositors will get higher interest rates on their fixed deposits.

Real estate sector would also get affected as the buyers decide to postpone their home purchases if they are not able to arrange for the 20% margin money.

With this rate hike, the interest rate differential between the developed economies and India has increased by 25 bps, which may lead to higher inflows by Foreign Institutional Investors (FIIs) into the debt sector. With higher FII inflows, export dependent sectors like Textiles and IT may also get negatively affected as the Rupee may witness appreciation in the short to medium-term due to the rate hikes.

Fundsupermart House View

The rate hikes were in line with the market expectations. Although RBI expects the economy to grow by 8.5% in the current fiscal year, the major domestic cause of worry is inflation and in particular, the structural nature of food inflation.

The next mid-quarter policy view is to be held on 16 December 2010. We are of the view that RBI may not go for a rate hike in the December meet. However, RBI may decide to continue the monetary tightening in the third quarter of FY2011 based on the level of inflation in December 2010 and the subsequent impact of the earlier rate hikes on inflation.

Fundsupermart Fund Picks

Investors with 6 to 12 months time horizon can continue to invest in short-term funds because the  liquidity situation is expected to remain tight in the short term.

Investors having a 12 months to 18 months time horizon can invest in FMPs and long-term Gilt funds as it is a good time to lock-in yield at the current high levels.


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