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Posted by: Deepa Vasudevan on Wed, Jun 13th, 2012

Pause the Party: Uncertainties Ahead

There are signals that RBI may cut interest rates and/or CRR in its June policy. Real GDP grew at 5.3% in Q4FY2012, and April 2012 IIP growth was at 0.1%-confirming that the economy has indeed slowed down. Global crude prices have declined, and commodity prices are expected to remain moderate this year. Inflation expectations have reduced, and may go down further in Q2 if these trends continue. Macro indicators seem right for monetary easing.


The State Bank of India- the leading public sector bank- has reduced short-term deposit rates by 25 basis points in anticipation. Other banks are likely to follow, and reduce their cost of funds, so that lending rates can be lowered once RBI officially cuts policy rates. Markets have already started discounting a rate cut. G-sec yields have fallen across the spectrum; money market rates have also declined in Apr-June quarter (Table 1).


Table 1 Rates in the Money Market


Rates in the Money Market

Source: CCIL


There is more good news. A normal monsoon is forecast this year. Petrol prices have been increased, taking some pressure off the fiscal deficit. China has lowered key lending and deposit rates, which is expected to boost growth domestically as well as for its trading partners.


Naturally, market sentiment is up: the BSE-Sensex gained 5% in the first week of June on the hope that rate cuts would stimulate investment and consumption and push up GDP. Markets have found a rallying point after many months of bad news.


A significant contributor to the positive sentiment is the improved liquidity in Q1FY2013. Daily bank borrowings through LAF repo auctions were around Rs.85,000 crore in the first week of June, which is half of the peak level of Rs. 1.5 lakh-2 lakh crore seen in March 2012 (see Pic 1).


LAF Repo and Reverse Repo Volumes

Source: CCIL

However, there is no guarantee that liquidity will remain comfortable throughout the year. To understand why, consider this situation.


Suppose the Euro crisis worsens to the point where Greece, or Spain, or some other country is forced to exit the EU. There will be massive financial losses for many entities within and connected to the Euro area. But more importantly for India, foreign investors will become risk averse and pull out money from our capital markets. This will set off a familiar chain of events:

  • A high current account deficit with insufficient foreign inflows depreciates the Rs/$ rate
  • RBI intervenes by selling dollars and thereby drains rupees out of the system
  • Liquidity dries up and short term rates rise
  • RBI steps in again with open market operations (OMOs) to infuse liquidity.


Meanwhile, the government continues to borrow heavily from the market. To facilitate that, more OMOs may be needed. Since the overall investment climate is likely to be poor, banks would prefer to invest in g-secs (of which there will be an abundant supply) which are useful for OMOs as well as LAF borrowing. There will be no credit uptick or growth revival.


Is this possible? Absolutely. This is what happened between September 2011 and March 2012. Table 2 shows a simple calculation of the impact of capital account inflows on liquidity in that period: a deficit of Rs.654 billion was set up just on account of these push-pull factors.


Table 2: Activities that increased and decreased liquidity


Activities that increased and decreased liquidity

Source: RBI, Ministry of Finance India 


The exchange rate continues to be fairly volatile in FY2013. RBI sold dollars worth $ 136 billion in April. Intervention in May -when the exchange rate lost 6.6%- was probably much higher, but data will be available only in July*.  Meanwhile, there are reports that India-centric overseas funds have seen massive outflows due to policy uncertainties. Domestically, there is a risk that bank deposit growth will not pick up especially if deposit rates are dropped. In FY2012, despite a credit slowdown, poor deposit mobilisation created a credit-deposit divergence that forced banks to seek out alternate funding sources. If bank credit goes up in the second half of FY13 on the back of easier money, then bank liquidity could be under more pressure.


The present situation is best described as a temporary sweet spot. Uncertainties- both external and domestic - can quickly trigger panic in the money/forex/inter-bank markets. Until they subside, it may be better to postpone celebrations, and just wait and hope.

* CCIL data show that foreign currency reserves of RBI declined by about $10 billion in May. Much of that erosion in reserves should be the outcome of intervention; but it is impossible to confirm until official data comes in.

sandeep on Sun, Jun 17th, 2012 11:31:04 am

need some explanation on inflation,dollers hike and industrial growth(-),now our finance min. is majorly concern about these points.what are the key factors effect to control all these factors.

Karun Reddy on Fri, Jun 15th, 2012 11:19:17 pm

The markets in the last few months are moving in correlation with Rupee. If rupee doesn't go below 54.30 levels it most probably peak out anywhere between 58-60 and inline with it markets would bottom out a little below the recent lows. ELSE, just as Ms Deepa Vasudevan said this would endup as a trap/sweet spot. One should not be surprised if rupee would zoom past 60 levels and inline with it sensex tumbles. One may call its because of "Europe troubles, fresh US news or own internal growth rate and poor governance" Let's keep fingers crossed and wait for the possible outcome.

Joseph Kurian on Fri, Jun 15th, 2012 2:07:58 pm

Good Report on the event which we all are keenly waiting.. Thanks for the same... Keep posting such report on Market, Economy and on a Global Front too.

Ramesh Kumar Nanjundaiya on Thu, Jun 14th, 2012 6:48:35 pm

Generally speaking if today India today were to have two quarters of lower GDP than the previous quarter, (which seems to be case) it could be construed as tending towards a recession. Recessions tend to come twice a decade historically, and some are more severe than others. Prolonged recession is called a depression. However, the definition of a depression has never been set by economists. Suffice it to say that economic growth is generally on the negative side for many quarters. For some jurisdictions, economic growth is better measured through other means, though these are usually local anomalies. For example, a city receiving most of its money through property taxes may consider it economic growth if property values go up. They may deduce because property values have increased, people are making improvements. If they are making improvements, economic growth is taking place. This may or may not be an accurate assumption. If suppose RBI decides to cut interest rates (on loans and deposits), will it help stimulate GDP, not necessarily. The GDP growth needs to be seen in totality. The public at large may be tempted to measure economic growth through job creation numbers. This is especially important to the general public, who could hardly care less about production numbers. If jobs are being created, that means wealth is being created and spread. This may be, perhaps, one of the best measures of economic growth or GDP growth. If jobs are not being created or are being lost, this generally leads to a depressed economic state, especially for those affected individuals and perhaps for the country as a whole. If the majority of the factories in a country are working and the workers continue to earn their wages and still industrial production of the country is 0.1% (which is the case with India currently), there is something seriously wrong. Economic growth means different things to different people. While economists, governments and individuals may all have their own opinions about what should constitute the GDP growth, the truth is all of these things working together help create an overall healthy economy. RBI is just the first gear in a car. There are 4 gears as well as a reverse gear for a car to run.

Dwarakanath on Thu, Jun 14th, 2012 6:43:47 pm

Thanks for the report. This will help all those who are involved in the financial sectors to understand the things better

M Venkataraghavan on Thu, Jun 14th, 2012 5:54:58 pm

Madam, Thnks for the detailed and simple report

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