CRISIL : Monetary Policy Review

June 2014

CRISIL Monetary Policy Review

Hint of dovishness on Mint Road

Overview: In its monetary policy meeting today, the Reserve Bank of India (RBI) held the repo rate steady at 8% -- as was widely expected. The central bank reiterated its resolve to bring down and sustain CPI inflation below 8% by January 2015 and further to

6% by January 2016. The RBI said if the economy stays on course, further policy tightening will not be warranted and faster-than- anticipated disinflation will provide room for easing.

Headline inflation increased to 8.6% in April after recording a decline in the first two months of the year (Chart 1). Core CPI inflation has edged down slightly, but remains high at around 8%. It is yet to feel the full impact of interest-rate hikes undertaken by the RBI between September 2013 and January 2014. Recent upward movement in headline inflation was due to higher vegetable & fruits prices (Chart 2) on the back of weather related disturbances and may prove to be transitory. In the coming months, a strong base effect of high inflation during June-November 2013 could soften CPI inflation. The big worry is the enhanced possibility of a recurrence in the El Nino this year, which could lead to weaker-than-normal monsoon, cranking up food inflation. Given the uncertainties, the RBI's decision to hold interest rates steady is appropriate.

Monsoon is an uncontrollable risk but our research shows that food inflation spikes even in normal-monsoon years. In our recent report ( What a Waste!-- released on June 2), we argue that there is more to food inflation than supply struggling to catch up with demand. Farm growth has improved in recent years, yet food inflation has shot up. This is clearly because of inefficiencies in the farm-to-fork ecosystem and wastage of food items - specifically, food grains, fruits and vegetables. The primary mission for the new government therefore is to improve the supply chain and reduce wastage, pilferage and develop efficient agricultural markets, as discussed in our report.

The second factor that will give cues for future monetary policy decisions is fiscal discipline. The forthcoming Union Budget will be a litmus test on this count. Swift action by the government to tame food inflation and commitment to fiscal discipline will pro vide the RBI the elbow room for a pro-growth monetary stance.
Controlling food inflation, and hence headline inflation, is even more pertinent as the revival in growth -- in this fiscal and the next -- can limit the moderation in core inflation. The RBI maintains its baseline projection of GDP growth in FY15 at 5.5%. We expect growth to be higher this fiscal at 6% compared with 4.7% in FY14, led by a turnaround in industry.
In an effort to provide more room to banks to finance higher investment demand as the economy recovers, the RBI reduced the statutory liquidity ratio by 50bps to 22.5% of net demand and time liabilities. Also, it reduced the liquidity provided under the export

credit refinance facility from 50% of eligible export credit outstanding to 32% in Tuesday's meeting.

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CRISIL Monetary Policy Review

Figure 1: Inflation moves away from the RBI's target Figure 2:… as food inflation picks up

Source: CSO, CRISIL Research Note: values for sub -com ponents show contribution to % yr food inflation

Source: CSO, CRISIL Research

Credit growth expected to improve in 2014-15

 Aggregate bank credit growth slowed to 13.3 per cent y-o- y as on May 16, 2014 from 14.7 per cent as on May 17,

2013, due to sluggish investment demand and increased risk aversion given the deterioration in public-sector banks' (PSBs') asset quality.

 Advances for Scheduled commercial banks (SCBs) grew by 14.8 per cent y-o-y in 2013-14. However, growth for small and mid-size PSBs was only ~10 per cent due to lower capital adequacy ratio and asset quality issues.

 We expect credit growth in the banking sector to improve to 16-18 per cent in 2014-15, especially in the second half given the decisive mandate at the elections.

Figure 3: Credit growth (y-o-y)

20%

18%

16%

14%

12%

10%

Source: RBI, CRISIL Research

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Deposit growth to accelerate to 15-16 per cent in 2014-15

 Growth in bank deposits accelerated to 14.2 per cent y-o-y, as of May 16, 2014, from 13.5 per cent as of May 17, 2013. This increase can be attributed to a surge in the foreign currency non-resident (FCNR) deposits. Banks garnered almost $26 billion (Rs 1.5 - 1.7 trillion) in September - November 2013, under FCNR deposits.

 Bank deposits are forecast to grow at around 15-16 per cent in 2014-15, a tad higher than that in 2013-14. With expected moderation in CPI inflation, real returns on

deposits will turn positive

Figure 4: Deposit growth, y-o-y

18%

16%

14%

12%

10%

Source: RBI, CRISIL Research

Asset quality challenges to peak in 2014-15

 Gross Non performing asset (GNPA) stood at 3.8 - 4.0 %

Figure 5: Trend in asset quality

(per cent)

levels by March 2014. We expect moderation in slippages and sale to ARCs to contain NPA levels at ~4%.

 The asset quality of PSBs continued to be under pressure, with gross non-performing assets (GNPAs) at 4.26 per cent of advances (as of March 2014)- an increase of 59 bps on y-o-y basis. The asset quality of private sector banks, on the other hand, remained relatively robust, with GNPAs at

1.73 per cent of advances.

 We expect weak assets (Reported GNPA + 30% of outstanding restructured advances (excluding state power

6.0

5.5

5.0

4.5

4.0

3.5

3.0

2.5

2.0

3.7

2.9

4.3

3.3

5.6 5.7

3.9 4.0

utilities) +75% of investments in security receipts) in the system to stabilize at ~ 5.7% by March 2015, after witnessing a sharp increase to 5.6% in March 2014 from

4.3% in March 2013.

Gross NPAs (%) Weak assets (%)

Source: RBI, CRISIL Research

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CRISIL Monetary Policy Review

CD ratio to remain high

 The credit deposit (CD) ratio of banks reached a historical high of 80.3 per cent in 2012-13. With higher accretion to deposits in comparison with growth in credit, the CD ratio moderated during the second half of 2013-14.

 The CD ratio stands at 76.9 per cent as of May 16, 2014.

Compared with September 06, 2013, the current CD ratio is down by almost 132 basis points (bps). The drop can be attributed to rapid accretion to FCNR (B) deposits, which saw a surge during September- November and slowdown in credit demand. Incremental CD ratio too has fallen from
101.3 per cent as of September 06, 2013 to 72.6 per cent as of May 16, 2014.

 While the credit demand is not expected to revive dramatically, pace of deposit accretion too is likely to remain moderate. Consequently, we expect the CD ratio to remain elevated even in 2014-15.

 Reduction of Statutory Liquidity Ratio (SLR) by 50 basis points to 22.5% of NDTL from 23.0%. SLR reduction is more of an enabling step, aimed at helping banks meet credit demand as and when it recovers. As of May 2014, SLR was higher by 4-5 % levels than the minimum required and thus this measure will not have any near term

impact on liquidity.

Figure 6: Trend in CD ratio

110%

100%

90%

80%

70%

60%

50%

Incremental credit -deposit ratio Credit-deposit ratio

Source: RBI, CRISIL Research

Lending rates to stay high; NIMs to improve marginally in 2014-15 Figure 7: Net interest margins (NIMs)

 With no change announced in the repo rate, the overall cost of funds for banks is expected to remain at elevated levels. With traction in deposits, the supply of funds has improved in recent past, lowering the dependence on borrowings from the RBI. Inter-bank money market rates too have declined by 75-100 bps in the past 6-9 months.

 Nevertheless, we expect lending rates to remain high amidst concerns on asset quality and an elevated CD ratio.

 Average net interest margins (NIMs) declined by 15 bps y- o-y in 2013-14 due to high cost of funds, rising delinquencies, and increased competition. PSB's net interest margins (NIMs) declined by 19 bps y-o-y due to a higher proportion of non-earning assets. NIMs of private sector banks, in contrast, expanded by 12 bps on a y-o-y basis, led by lower interest expenses on account of favourable changes in the liability mix and higher credit- deposit ratio.

 NIMs are expected to improve marginally in 2014-15 by 10-

15 basis points with improved demand and re-pricing of high interest rate deposits raised in the earlier years

(per cent)

3.5

3.4

3.3

3.2

3.1

3.0

2.9

2.8

2.7

2.6

Source: RBI, CRISIL Research

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Last updated: May, 2013

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