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RBI keeps rates unchanged, tightens liquidity

30 September 2014

The Reserve Bank of India (RBI) has kept its policy rates unchanged for a fourth straight time at its bi-monthly monetary policy review, continuing its fight against a persistent inflation, despite pressures from industry to lower interest rates to support flagging industrial production.

RBI Governor Raghuram RajanRBI today left the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 8.0 per cent and kept the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time liabilities (NDTL), as it continued to keep track of the inflation and its effects on overall economy.

The central bank, however, reduced the liquidity provided to banks under the export credit refinance (ECR) facility from 32 per cent of eligible export credit outstanding to 15 per cent with effect from 10 October 2014.

Accordingly, RBI said, the reverse repo rate under the LAF will remain unchanged at 7.0 per cent, and the marginal standing facility (MSF) rate and the bank rate at 9.0 per cent.

RBI said it would continue to provide liquidity under overnight repos at 0.25 per cent of bankwise NDTL at the LAF repo rate and liquidity under the 7-day and 14-day term repos of up to 0.75 per cent of NDTL of the banking system through auctions and continue with daily one-day term repos to smooth liquidity.

Retail inflation measured by the consumer price index (CPI) eased with a fall in vegetable prices and almost all major groups barring food. Food prices have contributed almost 60 per cent of headline inflation in August.

However, future food prices and the timing and magnitude of held back administered price revisions impart some uncertainty to an otherwise improving inflation outlook, where lower oil prices, a relatively stable currency, and a negative output gap continue to put downward pressure, RBI said.

The base effects will also temper inflation in the next few months only to reverse towards the end of the year and RBI said it would look through the base effects.

RBI noted that headline inflation continued to ebb, since June, to levels which are consistent with the desired near-term glide path of disinflation - 8 per cent by January 2015.

''The most heartening feature has been the steady decline in inflation excluding food and fuel, by a cumulative 111 basis points since January 2014, to a new low,'' RBI said.

With international crude prices softening and with relative stability in foreign exchange market, some upside risk to inflation are receding. Yet, RBI said, there are risks from food price shocks as the full effect of monsoon's passage unfold and from geopolitical developments that could materialise rapidly.

For the near-term objective, RBI said, the risks around the baseline path of inflation are broadly balanced, though with a slant to the downside.

Turning to the medium-term objective (6 per cent by January 2016) the balance of risks is still to the upside, though somewhat lower than in the last policy statement, the central bank said.

While domestic economic activity appears to have come off somewhat after the stronger-than-expected upturn in Q1 of 2014-15, growth in industrial production slumped in Q2, in July, as capital goods production followed consumer durables into contraction.

Exports cushioned the fall in manufacturing output, with the RBI's industrial outlook survey indicating expansion in export orders.

Rainfall from the south west monsoon, now expected to be about 12 per cent deficient, will weigh on the kharif crop, mainly due to its uneven spatial distribution. This has resulted in drought-like conditions in some major production zones in the north-west region but also floods in the northern and eastern regions.

On the external front, RBI noted that apart from concerns about a sudden correction in financial markets if investors misread the timing of a reversal of the US monetary policy stance or if geopolitical tensions intensify, some downside risks to growth also persist, such as a possible further slowdown in the Euro area.

In the service sector, constituents are moving at varying speeds and the purchasing managers' index points to uncertainty around future prospects.

The recent cautious optimism that is building in the economy on the back of improved business sentiment needs to be placed on solid foundations through a step-up in investment. In this context, the resumption of stalled projects should provide a boost to inventory and capex cycles, while reducing distressed bank loans and revitalising growth.

Liquidity conditions have remained broadly balanced through Q2 of 2014-15, except for transient tightness in the second half of July and early August due to delayed government expenditure. Thereafter, as these expenditures began to flow, liquidity conditions eased.

With credit growth falling well below deposit growth in August and September, structural sources of liquidity pressures also eased. The average recourse to liquidity from the Reserve Bank, measured by daily net liquidity injection through LAF, term repo and MSF, decreased from Rs87,000 crore in July to Rs79,500 crore during August and further to Rs45,000 crore during September so far (up to 28 September).

Non-food credit growth decelerated in September 2014, the lowest level since June 2001, despite liquidity conditions remaining comfortable and deposit growth remaining normal.

While this could be partly due to a high base monetary tightening to curb the exchange market pressures in July-September last year, corporates have also opted to raise financing through alternative sources such as commercial paper, which are significantly larger than a year ago.

Finance from other non-bank sources such as foreign direct investment and external commercial borrowing has also increased.

Also, a few banks have sold stressed loans to asset reconstruction companies, and so these loans no longer appear as bank credit. Net bank credit is also lower because of repayments of loans by entities that have received payments by government departments and public enterprises, and because oil marketing companies' borrowing is lower.

Finally, the slowdown in credit growth is more pronounced in public sector banks, but how much of this is because of needed bank balance sheet restructuring, repayments of stressed loans, or increased risk aversion is to be established.

Going forward, as the investment cycle gathers momentum and overall demand picks up, banks will need to prepare to meet financing requirements as the credit cycle also turns. Equally, given the easy availability of foreign finance, corporations should be wary of being lulled by relative exchange rate stability and neglect to hedge foreign exchange liabilities.

Incoming data suggest that the current account deficit, placed at 1.7 per cent of GDP for Q1 of 2014-15 may remain contained in Q2, RBI added.

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