Highlights of RBI's FY11 Annual Policy Statement

Following are the highlights of the Reserve Bank of India's Annual Policy Statement for 2010-11 (Apr-Mar):

MAIN HIGHLIGHTS

·         Hikes reverse repo, repo rate, CRR by 25bps each

·         Reverse repo, repo rate hikes with immediate effect

·         CRR hike effective from Apr 24

·         CRR hike to impound 125 bln rupees from banks

·         FY11 GDP growth projection at 8.0% with upside bias

·         March end inflation projection at 5.5%

·         FY11 banks' credit growth projection at 20.0%

·         FY11 banks' deposit growth projection at 18.0%

·         FY11 money supply growth projection at 17.0%

.

STANCE

·         Hike in policy rates, CRR to help contain inflation

·         Hike in policy rates, CRR to anchor inflationary expectations

·         Measures to sustain recovery process

·         Govt borrow needs, private credit demand will be met

·         Hikes to align policy tools with evolving state of econ

·         To closely monitor macro events, prices; take warranted steps

·         Econ firmly on recovery path, industrial growth broad based

·         India economy resilient, recovery consolidating

·         FY11 econ growth to be higher, more broad-based vs FY10

·         Lower policy rates can complicate inflation outlook

·         Lower policy rates also impair inflationary expectations

·         Despite 25bps hike in rates, real policy rates still negative

·         Need to normalise policy rates in calibrated manner

·         Inflationary pressures "accentuated" in recent period

·         Inflation getting increasingly generalised

·         Capacity constraints to re-emerge as econ growth rises

·         Must ensure demand-side inflation does not become entrenched

·         FY11 fresh govt bond issuances 36.3% higher vs FY10

·         FY11 fresh govt bond issuances "a dilemma"

·         Policy considerations demands liquidity be curbed

·         Govt borrow needs supportive liquidity conditions

·         Need to absorb liquidity without hurting govt borrow plan

·         To respond swiftly, effectively to inflationary expectation

·         To actively manage liquidity, ensure private credit demand is met

INFLATION

·         Significant changes in drivers of inflation in recent months

·         Overall food inflation high despite seasonal ease

·         Rise in global commodity prices upside risk to inflation

·         Household inflation expectations remain at elevated level

·         Demand pressures may rise as recovery gains momentum

·         Monsoon prospects unclear, blur FY11 inflation outlook

·         Volatile crude prices cloud FY11 inflation outlook

·         To ensure price stability, anchor inflationary expectations

·         To monitor overall, disaggregated components of inflation

·         keeps medium-term inflation objective of 3.0%

·         An unfavourable monsoon may exacerbate food inflation

·         Unfavourable 2010 monsoon may add to fiscal burden

.

GROWTH

·         GDP projection assumes normal monsoons

·         GDP projection also assumes good industrial, services growth

·         Industrial growth to take firmer hold going forward

.

FISC

·         Fiscal prudence to avoid crowding out private credit demand

·         Fiscal prudence must shift to structural improvements

·         Govt borrow "very large", can pressure interest rates

.

GLOBAL

·         Pace of global econ recovery remains uncertain

·         Uncertain global econ recovery downside risk to India GDP

·         Trade, financial linkages to other economies may impact India GDP

·         Commodity price seen up more if global recovery gain momentum

·         Rise in global commodity prices may up inflation pressure

·         Expansionary fiscal policy may not be unwound in advanced economies

·         Expansionary policies may trigger large FX flows to India

·         Excessive flows challenge to FX rate, monetary mgmt

·         FX rate policy not guided by pre-announced target

·         Keep flexibility to intervene in FX market to manage volatility

·         Need to be vigilant volatile FX rate movements

.

MARKET

·         RBI panel to mull single point reporting for OTC FX derivatives

·         To launch reporting platform for secondary deals of CDs, CPs

·         Asked FIMMDA to develop CD, CP reporting platform

·         To allow banks to purchase non-SLR bonds by infra companies in HTM

·         OKs bourses to launch plain vanilla dollar/rupee options.

Impact of Union Budget 2010 on our Economy and Markets

Impact on the Economy:

The Union Budget 2010-11 presented on Friday has several important implications for the

economy as well as equity and debt markets for the year ahead. Broadly speaking, the

government aims to improve its finances by reducing subsidies and normalizing indirect taxes

even as it has reduced income taxes on individuals. Over the last couple of years, because of

the macro-economic crisis and rise in subsidies due to high commodity prices, the

government’s finances weakened considerably and the government has announced a multiyear

road map to improve its finances. Specifically this budget aims to reduce the gap between

the government’s overall revenue and expenditure, called fiscal deficit, from 6.7% in FY2010 to

an estimated 5.5% in FY2011.

The most important driver of improving long-term finances, and indeed generating surpluses

necessary for investment, is growth in economic activity. The budget has either maintained the

momentum, or increased it, as far as demand drivers of the economy are concerned with more

allocations to various development and infrastructure segments. We believe that reduction in

income taxes on individuals, will put more money into the hands of consumers who in turn will

provide a boost to private sector demand. This will also partly neutralize the impact of the rise

in prices that will happen in various segments, such as petrol and diesel prices, on account of

reduction in subsidies. GDP which is on an improving trend overall, notwithstanding the impact

of weak monsoon, will maintain the momentum in FY2011 and will show a higher GDP growth

rate than FY2010. As such the budget for the overall economy is growth enabling even though it

is likely to be mildly inflationary.

Impact on Equity Markets:

What is good for economy is usually good for equity markets. We believe the budget will

provide an additional boost to the already strong domestic demand, particularly in the

consumption-oriented segments. From corporate revenue and earnings perspective, the

budget has positives for consumer sectors such as Auto, negatives for cement and realty

sectors and is neutral for banking sector. Also this budget is likely to enable a positive

environment for infrastructure and capital goods sectors, given the increased outlays and

additional tax break on infrastructure bonds. Overall the budget does not alter our view that

FY2011 will be a year of economic revival, and also a year of strong growth in corporate

earnings which is a significant improvement from the flattish trend observed over last two

years.

While growth in earnings will remain robust, however the market valuation multiple is likely to

remain capped, closer to the long-term trend line levels of 14-15 times one-year forward

earnings, given the government’s planned disinvestment target of Rs 40,000 Cr for next year.

We believe that there is a case for range bound markets in the short-term driven by factors like

current valuations and likely supply of paper on account of fresh issuances in the backdrop of

resurgent economic growth and capital flows.

Impact on Fixed Income markets:

The government has taken the first step towards fiscal consolidation by reducing the deficit to

more sustainable levels in the Union budget for FY2011. The government announced a fiscal

deficit target of 5.5% of GDP for FY2011 compared to a deficit of 6.7% of GDP registered in

FY2010. The government aims to achieve this through:

•  Improvement in tax to GDP ratio by increasing excise duty rates, Minimum Alternative Tax paid by corporates and increasing the scope of service tax
• Less than expected increase in overall expenditure
• Higher receipts through disinvestment and auction of 3G telecom licenses

As a result the net market borrowing program for the FY 2010-11 has been reduced to Rs.

345,010 cr compared to Rs. 398,411 cr for the FY 2009-10. The commitment by government to

further reduce its fiscal deficit to 4.1% of GDP by in FY 2012-13 is likely to lead to lower interest

rates in medium term.

However there may be some pressure on government security yields in the near term as the

government hits the market with next year’s borrowing program in an environment

characterized by rising inflation, possible interest rate hikes by RBI and possibly no support

from RBI in the form of Open Market Operation (OMO) purchases of government securities. As

a result yields may gradually drift higher from current levels and peak out some time in the first

half of next fiscal.

Overall this as an economy friendly budget in the medium to long term due to positive intent

shown by the government in the areas of social spending, fiscal consolidation and tax reforms.

While the view on equity markets is one of range-bound markets or on debt markets is one of

pressure on yields in the near term, no long-term savings or investment decision should be

taken based on short term outlook of the markets. India remains one of the fastest growing

economies in the world, least impacted by global crisis, and therefore Indian equity and fixed income securities remain an attractive investment opportunity in the long-term savings

portfolio.