RBI ends easy money regime

CENTRAL BANK SHIFTS FROM 'MANAGING CRISIS TO MANAGING RECOVERY' IN Q2 REVIEW

No change in rates, moves to reform financial sector.

The Reserve Bank of India (RBI) on Tuesday signalled an exit from a loose monetary policy and surprised the market by tightening norms for loans to commercial real estate. It also asked banks to increase the provision cover for sticky assets in an attempt to control inflationary expectations and a build-up in asset prices.

Most market players said they think the central bank has laid the groundwork for a rise in interest rates in the next quarter.

Though RBI left key policy rates unchanged, Governor D Subbarao on Tuesday summed up his monetary policy stance by saying 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.” He said there were “definitive” indications that the economy was recovering, though growth still remained “fragile”.

As part of the first phase of the exit, Subbarao restored the statutory liquidity ratio (SLR), or the proportion of deposits invested in government paper, to 25 per cent of net demand and time liabilities of each bank from the fortnight starting November 7. Last year, at the height of the financial crisis, RBI had lowered the SLR to 24 per cent to help banks generate cash. But the latest move was unlikely to affect banks' liquidity adversely, as scheduled commercial banks had SLR investments of 27.6 per cent .

However, the increase in the provisioning requirement for loans to commercial realty will increase the cost of funds for developers, which they could pass on to buyers, including those opting for affordable housing units. The move was initiated as the loan flow to commercial real estate was rising at 40 per cent year-on-year and nearly one-seventh of the loans to the sector had been restructured by banks.

Similarly, the move to increase the loan loss coverage ratio to at least 70 per cent by September 2010 was expected to affect banks' profitability, since they will have to set aside more funds for meeting the new stipulation. While at the industry level the coverage ratio is 51 per cent at present, a host of banks led by State Bank of India and ICICI Bank would face a heavy burden.

The Bombay Stock Exchange Sensitive Index (Sensex) fell 2.5 per cent, with the realty index being the biggest loser, shedding 6.2 per cent. The Bankex also fell by 3.8 per cent.

Though RBI turned down a plea from banks to allow them to keep more government securities in the held-to-maturity category, to help them avoid provisioning at a time when yields are high, bond yields fell on Tuesday after the central bank raised the SLR requirement.

RBI, which has been under pressure from the government to maintain a loose monetary policy, kept its growth forecast for 2009-10 unchanged at 6 per cent, with an upward bias, but raised the inflation estimate to 6.5 per cent by the end of March.

The central bank said there was a “critical need” for the government to borrow less and help sustain moderate interest rate levels. So far, Australia is the only Group of 20 economy to raise rates amid signs of an easing in the global crisis, but India and South Korea are expected to follow its lead in the months ahead.

RBI, however, took a cue from the G-20 and decided to release guidelines on limiting compensation package for private and foreign bank branches.

The central bank also took several measures to push ahead with a broader financial sector reform agenda. The scope of currency futures has been increased from just rupee-dollar transactions to cover the euro, the pound and the yen, allowing participants to directly hedge exposures in these currencies.

Also very basic credit default swaps have been introduced, providing banks a low-cost way to insure their loan exposures.

A proposal endorsed by the Committee on Financial Sector Reforms to introduce tradable Priority Sector Lending Certificates, a measure that can significantly increase both the volumes and efficiency of priority sector lending, has been taken on board and a group set up to operationalise the scheme.

RBI also liberalised the bank branch opening policy. Going forward, banks will not need RBI permission to open branches in rural and semi-urban areas but they will need to get RBI’s nod to expand in tier-I and II cities.

Effective immediately, the RBI ended a special repurchase facility for banks and another for the funding needs of non-bank financial companies, mutual funds and housing finance companies.

In the review, RBI said bank credit remained sluggish and cut its forecast for adjusted non-food credit growth in 2009-10 to 18 per cent from 20 per cent. “Banks are urged once again to step up their efforts towards credit expansion while preserving credit quality which is critical for revival of growth,” it said.

At the same time, it asked bank chiefs to maintain caution on investment in mutual fund instruments.