MONETARY POLICY-

RESERVE BANK OF INDIA

MID-TERM REVIEW OF
SEPTEMBER 2010

Rama Krishna Vadlamudi, HYDERABAD September 22, 2010

India’s national income (GDP) has expanded by 8.8 per cent during the first quarter of
2010-11. The Index of Industrial Production (IIP) has gone up by 13.8 per cent in July 2010
compared to the same month last year. Services sector in India is booming. With bountiful
monsoon, Agricultural Production is expected to post buoyant growth. Food inflation is more
than 15 per cent. Inflation based on Wholesale Price Index (WPI) remains almost at more
than 10 per cent since February 2010; though it has come down to 8.5 per cent in August
2010 (base year: 2004-05). India’s imports have risen substantially in the last few quarters,
while export growth continues to be mild. Global recovery seems to have faltered in the last
few months.

Against this backdrop, the Reserve Bank of India (RBI), in its mid-quarter review of
Monetary Policy announced on September 16, 2010, has raised policy rates to contain
inflation. This Mid-term Review of Monetary Policy by RBI is the first of its kind, whose
introduction was announced by RBI in the July 2010 Quarterly Review.
 Rama Krishna Vadlamudi, HYDERABAD September 22, 2010
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Monetary Measures:

The following are the monetary measures undertaken by RBI on September 16, 2010:

1) LAF-Repo Rate is increased by 25 basis points to 6.00 % wef Sept. 17, 2010
2) LAF-Reverse Repo Rate is hiked by 50 basis points to 5.00 % wef Sept. 17, 2010
3) The Cash Reserve Ratio (CRR) is kept unchanged at 6.00 %
4) Bank Rate has been retained at 6.00 %
5) Saving Bank rate has been kept unchanged at 3.50 %

LAF corridor further shortened:

LAF Corridor

350
Jul.2008
300
Mar.2002
250
Basis Points

200
Mar.2004 Nov.2008
150 Oct.2006 Jul.2010
Apr.2005 Sept.2010
100
50
0
Mar.2002 Mar.2004 Apr.2005 Oct.2006 Jul.2008 Nov.2008 Jul.2010 Sept.2010

LAF Corridor is the excess of LAF-Repo Rate over the LAF-Reverse Repo Rate. Between
July 2008 and now, the corridor was brought down aggressively from a high level of 300
points to 100 points. Liquidity Adjustment Facility (LAF) is a mechanism by which RBI
adjusts daily liquidity in the domestic money markets by injecting funds (at repo rate) or by
withdrawing them out (at reverse repo rate).

LAF corridor is important from the viewpoint of short-term interest rates. Short-term
interest rates, usually represented by call money rates, are supposed to move in a range
between repo rate and reverse repo rate. RBI would use this corridor to contain any
volatility in short-term interest rates.

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 Rama Krishna Vadlamudi, HYDERABAD September 22, 2010
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Impact on Markets:

RBI has been consistently raising policy rates and reserve ratios since February 2010. The
following table illustrates this:

POLICY RATE/RATIO HIKED FROM HIKED TO HIKE in basis points *

Cash Reserve Ratio 5.00% in Feb.2010 6% in Sept.2010 100

Repo Rate-LAF 4.75% in Mar.2010 6% in Sept.2010 125
Reverse Repo rate-LAF 3.25% in Mar.2010 5% in Sept.2010 175

* one per cent is equal to 100 basis points (bp)

Stock market has been ignoring these consistent policy rate hikes. Till now, the markets
have been blaming the RBI for “being behind the curve”, meaning that RBI is not raising
policy rates in line with the spiraling inflation. By ignoring the increase in policy rates till
now, the Market itself seems to be “behind the curve!” While RBI increased CRR by 100 bp
and repo rate by 125 bp in the last seven months signifying hardening of interest rates; the
benchmark Sensex has gone up from 16,000 plus level in February 2010 to 20,000 plus now,
showing a growth of almost 25 per cent. This is quite a surprising thing considering the fact
that consistent increase in interest rates is interpreted as a growth dampener for
corporate profits. In future, one can expect the market to price in the policy rate hikes and
the stock indices may show some weakness. However, it is difficult to tell at what point of
time the stock markets will fully reflect the ground realities; as long as the inflows come in
through the Foreign Institutional Investors (FII), who have been pouring money into India’s
stock markets. As per SEBI data, FII inflows into the stock market are around USD 17
billion or Rs 79,000 crore during the 2010 calendar year.

However, bond market has been pricing in, to some extent, the steps being taken by RBI to
contain inflationary pressures in the economy. While the Government borrowing has
increased substantially this year, the windfall revenues for the Government from telecom
auctions in 3G and broadband wireless access have boosted the confidence of the bond
market. But for these windfall revenues, the government bond prices would have fallen much
more.

Bank deposit rates will further go up. As of now, bank depositors are earning negative
interest rates. In the past few months, depositors are getting 7 to 8 per cent per annum
for three-year deposits; whereas inflation is more than 10 per cent. This means, inflation at
more than 10 per cent is eating away whatever pittance they earn from interest on their
deposits. Interest rates on home loans will be increased gradually. Corporate loan rates too
will be hiked as banks start raising their lending rates depending on the liquidity situation.
Rates of commercial deposits and commercial paper have already gone up substantially.

Page 3 of 5
 Rama Krishna Vadlamudi, HYDERABAD September 22, 2010
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Is RBI done with rate hikes?

In its mid-quarter review, the RBI has indicated that inflation rates have reached a plateau,
but cautioned that they would remain at higher levels for some more time. RBI expects
inflation to moderate after some time. Some experts believe that RBI’s rate hikes have
almost come to an end considering the fact that global growth remains muted as of now with
US unemployment rate stagnating at 9.6 per cent for several quarters.

However, some disagree with RBI’s optimistic view on anticipated inflation moderation. With
GDP growing at 8.8 per cent in first quarter and IIP surging to 13.8 per cent in July, it is
difficult to give credence to official figures and pronouncements on inflation. With robust
inflows in the form of portfolio money (FII inflows into stock market), inflation will remain
at elevated levels for considerable period of time. All indications are that the odds are
against the optimistic views being expressed by the Government functionaries and RBI.

RBI says, “Inflation remains the dominant concern in macroeconomic management.” Food
inflation is still a worrying factor in containing overall inflation for the RBI and the
Government. To sum up, one can expect more rate hikes from RBI in the coming quarters.

Data Integrity

Central Banks, in general, are known for their vagueness in policy pronouncements. However,
RBI was rather candid and expressed its doubts about the authenticity of index of
industrial production (IIP) figures put out by the Government authorities. The IIP showed a
tepid growth of 5.8 per cent in the month of June 2010; however, it surged to 13.8 per cent
in July 2010. These wild swings in monthly industrial production numbers impart an element
of confusion in the minds of policymakers and market players; thus making the monetary
policy formulation difficult for RBI.

RBI’s observation comes at a time when doubts have been expressed about the integrity of
India’s GDP data published by the Central Statistical Organization (CSO), a Government
body. It may be noted that the Government revised its first quarter GDP numbers for
2010-11 within 24 hours. GDP growth rate as measured by expenditure at market prices was,
at first, put at 3.7%; but, within 24 hours, it was revised upwards to 10%! It is no wonder
that India’s Prime Minister Manmohan Singh once remarked that, “India’s data are not
reliable!”

Notes:

FII-Foreign Institutional Investor

IIP-Index of Industrial Production
LAF-Liquidity Adjustment Facility of the RBI
RBI-Reserve Bank of India
SEBI-Securities and Exchange Board of India

Page 4 of 5
 Rama Krishna Vadlamudi, HYDERABAD September 22, 2010
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Disclaimer: Views of the author are personal.

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