Monetary policy: Biding time

Tight liquidity constrains RBI, but continued inflation concerns point to a possible rate increase in January.

As expected, the Reserve Bank of India (RBI) has kept policy rates steady, with liquidity strain over-riding inflation concerns. However, it announced a permanent cut of one percentage point in the statutory liquidity ratio (SLR) to 24 per cent of banks’ net demand and time liabilities (NDTL) and extended an additional one per cent temporary relaxation till January-end.

This effectively mirrors the existing temporary two-percentage-point liquidity adjustment facility (LAF) support. But, YES Bank Chief Economist Shubhada Rao points that the permanent cut has a more salutary effect on the markets. “This indicates RBI believes the liquidity tightness is not just a short-term phenomenon, as average net LAF repo (effective liquidity deficit gauge) was over Rs 1 lakh crore, more than double the RBI-indicated comfort level of one per cent of NDTL,” she sais.

RBI also announced G-sec purchases, which will inject up to Rs 48,000 crore additional liquidity next month and bring the deficit to Rs 50,000-55,000 crore. Bank of Baroda Chief Economist Rupa Rege Nitsure points out that resumption of government spending, foreign institutional inflows and delayed response to deposit rate increases will ease liquidity in the next quarter.

However, a key dampener is the inflation outlook. RBI acknowledged a potential upside risk to its March 2011 projection of 5.5 per cent. Nitsure sees inflation at 6.6 per cent by March 2011 and expects a 25-basis-point rise in policy rates in January and possibly another in March if inflationary pressures increase.

While 2010-11 credit growth is expected to match RBI’s estimate of 20 per cent, deposit growth will lag (given the slow growth seen year-to-date), despite the rise in deposit rates and negative real interest rates, says Rao. For banks, a Macquarie research sees an additional 50-100 basis point deposit rate rise keeping margins under pressure for some more quarters. Banks with high current and saving account continue to be top picks in this environment.