Rama Krishna Vadlamudi

CONTENTS I. EXECUTIVE SUMMARY

October 28th, 2009
PAGES 1 to 2 3 to 12 3 4 4 6 7 9 10 12

II. A DETAILED SYNOPSIS 1. Projections for the year 2. What has not been attempted? 3. Measures undertaken 4. Policy Developments in the pipeline 5. Financial Market Products 6. Impact of the Policy measures 7. RBI’s concerns 8. The controversy about raising HTM limit

I. EXECUTIVE SUMMARY
END OF THE ROAD FOR EASY MONETARY POLICY:
Reserve Bank of India had announced its second quarter review of its Annual Policy, popularly known as Monetary Policy, on October 27th. The highlights and impact of the policy document have been analyzed from a MACRO perspective. The Reserve Bank of India Governor, D Subbarao, has sent signals, in no uncertain terms, to the financial markets in India that the RBI is serious about the withdrawal of its accommodative monetary policy.
As part of the first phase of reversal, the so-called EXIT STRATEGY, the RBI has increased the Statutory Liquidity Ratio (SLR) to 25 per cent (from 24 per cent); increased the standard assets provisioning needs of banks to commercial real estate sector (CRE) from 0.4 per cent to one per cent; the limit for export credit refinancing facility is reduced to 15 per cent from 50 per cent of eligible outstanding export credit; and the special term repo facility given to scheduled commercial banks for funding to mutual funds, NBFCs, etc, is withdrawn with immediate effect. RBI termed these steps as the first phase reversal of its ‘unconventional’ measures it had undertaken after the collapse of Lehman Brothers Inc in the middle of September last year.

It may be recalled that the after the collapse of Lehman Brothers Inc in the middle of September 2008, RBI had undertaken a raft of measures between September 2008 and the early part of January 2009 to restore confidence in the financial markets, especially in the money markets. RBI has earned a lot of respect from around the world for its bold and innovative measures in response to the evolving situation in the country following the unfolding of global financial crisis triggered by the sub-prime market in the US. Several measures undertaken by the Reserve Bank since mid-September 2008 have augmented actual/potential liquidity in the system on the aggregate by Rs.5,85,000 crore. (We Indians show our mettle during times of crises. As they say, this is the end of good times for all stakeholders in the economy.) RBI has indicated that the country’s GDP growth will be around six per cent with an upward bias for 2009-10. The inflation based on wholesale price index (WPI) will be 6.5 per cent by the end of March 2010. What is noteworthy in the second quarter review of its Annual Policy is the choice of instruments used by the RBI to give clear signals of its ‘exit strategy’ to the markets. While keeping the CRR, LAF-Repo and LAF-Reverse Repo rates unchanged; it has chosen to increase SLR by 100 basis points to 25 per cent, instead of the usual CRR (cash reserve ratio) at this point of time. However, it is not clear why RBI has resorted to increasing SLR though it claims that the SLR increase will not have any impact on the liquidity situation in the banking system and it is part of the withdrawal of the so-called unconventional measures undertaken by RBI after September 2008. FINANCIAL MARKET PRODUCTS: Some praiseworthy decisions that are being introduced/considered are the following: 1. Expanding the currency pairs in currency futures trading from the existing US dollar-Indian Rupee to three other pairs, namely, Euro-INR, Japanese Yen-INR and Pound Sterling-INR; 2. Introduction of over-the-counter credit default swaps (OTC CDS); 3. Issuance of final guidelines on repo in corporate bonds; 4. Launch of STRIPS (Separate Trading for Registered Interest and Principal Securities) during this financial year; 5. Introduction of price-based auction in floating rate bonds (FRBs). The introduction of these new financial products will have a salutary impact in the financial markets. Already, we’ve a vibrant market in currency futures and interest rate futures, though their success rate is questioned by some market pundits. OTHER MEASURES: 1. Henceforth, Liabilities under CBLO (collaterised borrowing and lending obligation), a product of the Clearing Corporation of India Limited (CCIL), will attract CRR; 2. Banks are, from now onwards, are free to open bank branches in semi-urban and rural branches (tier 3 to 6 areas); 3. Risk weights of banks’ exposure to NBFCs is linked to the credit rating assigned to the NBFCs; 4. Banks have to maintain a total provisioning coverage ratio on their Non Performing Assets (NPA) at a minimum of 70 per cent.

Rama Krishna Vadlamudi, MUMBAI.

October 28th, 2009

Page 2 of 12

One striking feature that stares at our face on the morning of October 28th, a day after the announcement of second quarter of RBI’s Annual Policy, is the consensus view among the various leading business newspapers of the day. All of them have pointed out their take on the RBI’s review, as if in a well choreographed way, describing the policy as: THE END OF EASY MONEY POLICY. This is the headline that has splashed across all newspapers today. This pithily describes the overall view of the RBI’s second quarter review. The above executive summary details the various measures in a lucid manner. Now let’s look at the policy initiatives, actions and the implications of the review from various perspectives. This will be dividend different sections – measures undertaken, what is not touched, what is the rationale behind the moves and what is the impact on various markets as detailed in the contents stated above.

1. PROJECTIONS FOR THE YEAR

The baseline projection for GDP growth for 2009-10 is placed at 6.0 per cent with an upside bias The baseline projection for WPI inflation at end-March 2010 is placed at 6.5 per cent with an upside bias The indicative projection of money supply growth of 18.0 per cent set out in July 2009 is revised downwards to 17.0 per cent Aggregate deposits of scheduled commercial banks are projected to grow by 18.0 per cent.

Rama Krishna Vadlamudi, MUMBAI.

October 28th, 2009

Page 3 of 12

2. What has not been attempted?
Sometimes, it so happens, what is not said is more important than what is stated publicly. The same is true of RBI’s second quarter review of Annual Policy. Let’s look at issues where status quo is maintained: Bank rate is kept unchanged at six per cent CRR is kept unchanged at five per cent of Net Demand and Time Liabilities (NDTL) Repo rate, under Liquidity Adjustment Facility, is kept unchanged at 4.75 per cent Reverse Repo rate, under Liquidity Adjustment Facility, is kept unchanged at 3.25 per cent Presently, banks are permitted to hold statutory liquidity ratio (SLR) securities up to 25 per cent of their demand and time liabilities (DTL) in the ‘held to maturity’ (HTM) category of investments. Now, RBI has decided to keep HTM limit for SLR securities unchanged at 25 per cent of their Demand and Time Liabilities. (See the last page to know the real reasons on the rationale behind this entire controversy) At this point of time, RBI felt that it was not prudent to raise any policy rates as the growth is still fragile in the economy. In the current debate of growth versus inflation, RBI seems to be communicating to the financial markets that it wants to give more importance to growth in the economy until more data are made available which would confirm that a robust and irreversible growth in the economy is underway. RBI’s decision of keeping the policy rates intact has been hailed by many experts.

3. Measures undertaken
As part of the first phase of reversal, the so-called EXIT STRATEGY, RBI has undertaken the following measures in the quarterly review:
The Statutory Liquidity Ratio (SLR) is increased from 24 to 25 per cent of Net Demand and Time Liabilities (NDTL) with effect from November 7, 2009 as the liquidity situation remained comfortable. Scheduled Commercial Banks are currently maintaining SLR investments at 27.6 per cent of their NDTL, net of LAF collateral securities, and 30.4 per cent of NDTL, inclusive of LAF collateral securities. As such, the increase in the SLR will not impact the liquidity position of the banking system and credit to the private sector. Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 4 of 12

The limit for export credit refinancing facility is reduced to the pre-crisis level of 15 per cent from 50 per cent of eligible outstanding export credit with immediate effect The special refinance limit; and the special term repo facility given to scheduled commercial banks for funding to mutual funds, NBFCs, etc, have been withdrawn with immediate effect Other measures undertaken: The collateralised borrowing and lending obligation (CBLO) liabilities of scheduled banks were exempted from CRR prescription in order to develop CBLO as a money market instrument. Volumes in the CBLO segment have increased over the years, especially after the phasing out of the non-banks from the inter-bank market. The daily average volume in the CBLO segment, which was only Rs.6 crore in January 2003, is now over Rs.60,000 crore. Since the objective of developing CBLO as a money market instrument has been broadly achieved, it is proposed that: Liabilities of scheduled banks arising from transactions in CBLO with Clearing Corporation of India Ltd. (CCIL) will be subject to maintenance of CRR with effect from the fortnight beginning November 21, 2009. The provisioning requirement for advances to the commercial real estate sector classified as ‘standard assets’ is increased from the present level of 0.40 per cent to one per cent Domestic scheduled commercial banks are, from now onwards, are free to open bank branches in semi-urban and rural branches (tier 3 to 6 areas as identified in the Census 2001 with population up to 50,000) under general permission Risk weights of banks’ exposure to Non Banking Financial Companies engaged in infrastructure financing will henceforth be linked to the credit rating assigned to such NBFCs by the external credit rating agencies. Infrastructure NBFCs are entities which hold a minimum of 75 per cent of their total assets for financing infrastructure projects. Banks have been advised to maintain a total provisioning coverage ratio of 70 per cent, including floating provisions, against their Non Performing Assets (NPA). Banks should achieve this norm not later than endSeptember 2010.

Rama Krishna Vadlamudi, MUMBAI.

October 28th, 2009

Page 5 of 12

4. Policy Developments in the pipeline

While RBI has taken a slew of measures as part of its second quarter review of Annual Policy, there are several issues that are being tackled separately. Some of these issues are: Priority Sector Lending Certificates (PSLCs): The Committee on Financial Sector Reforms (Chairman: Dr. Raghuram G. Rajan), inter alia, recommended introduction of priority sector lending certificates (PSLCs) for purchase by banks for achieving the priority sector lending target. According to the Committee’s recommendation, PSLCs would be issued by registered lenders such as MFIs, NBFCs, co-operatives, and registered money lenders for the amount of loans granted by them to the priority sector, and also by banks for the amounts in excess of their stipulated priority sector lending requirements. These certificates could be traded in the open market, and banks having shortfall in meeting the priority sector lending targets could buy such certificates and thus meet the priority sector lending norms. The Committee further recommended that in the trading of PSLCs, the actual loans would continue to remain on the books of the original lender unlike in outright purchase of loan assets. However, the buyer bank would show the amount in its priority sector lending requirements. The seller of PSLC, if it is a bank, will take it off its priority sector lending requirements even though it will continue to carry the loan on its books. It is now proposed to constitute a Working Group to examine the issues involved in the introduction of priority sector lending certificates and make suitable recommendations. Introduction of Duration Gap Analysis for Asset Liability Management: The Reserve Bank had issued guidelines on asset liability management in February 1999, which, inter alia, covered aspects relating to interest rate risk measurement. These guidelines to banks approached interest rate risk measurement from the ‘earnings perspective’ using the traditional gap analysis (TGA). To begin with, the TGA was considered as a suitable method to measure interest rate risk. The Reserve Bank had, however, indicated its intention to shift to modern techniques of interest rate risk measurement such as duration gap analysis (DGA), simulation and value-at-risk over a period of time, when banks acquire sufficient expertise and sophistication in this regard. Since banks have gained considerable experience in implementation of the TGA and have become familiar

Rama Krishna Vadlamudi, MUMBAI.

October 28th, 2009

Page 6 of 12

with the application of the concept of duration/modified duration while applying standardised duration method for measurement of interest rate risk in the trading book, this is an opportune time for banks to adopt the DGA for management of their interest rate risk. With this move, banks would migrate to the application of the ‘economic value perspective’ to interest rate risk management. Accordingly, it is proposed to issue detailed guidelines on the use of DGA for management of interest rate risk by end-November 2009. Liquidity Risk The Annual Policy Statement of April 2009 proposed to place the draft circular on liquidity risk management, as also the guidance note on “Liquidity Risk Management” on the Reserve Bank’s website by mid-June 2009. This was deferred. Keeping in view active discussions underway at the global level on liquidity risk management as the BCBS is also in the process of enhancing the modalities for adopting the integrating risk management system, it is now proposed to issue a draft circular reflecting these changes by end-December 2009. Stress Testing The Annual Policy Statement of April 2009 proposed upgradation of the stress testing guidelines once BCBS finalises the paper on ‘Principles for Sound Stress Testing Practices and Supervision’. In this context, the guidelines issued to banks in June 2007 are required to be enhanced in the light of the final paper issued by BCBS and taking into account international work/initiatives in the area of stress testing, particularly that being done by the IMF and the FSB. It is proposed to issue guidelines to banks on stress testing by end-January 2010.

5. FINANCIAL MARKET PRODUCTS
One important aspect of this monetary policy is the introduction of a host of financial market products in the country. Reserve Bank of India is considered as highly conservative when it comes to introduction of new financial products, be it derivatives or swaps. Reserve Bank of India, in consultation with the Securities and Exchange Board of India, has recently issued guidelines for exchange-traded interest rate futures. Accordingly, National Stock Exchange launched interest rate futures (IRFs) on August 31, 2009.
Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 7 of 12

TO KNOW MORE ABOUT INTEREST RATE FUTURES, JUST CLICK:
http://www.scribd.com/doc/19236501/Interest-Rate-FuturesIRFVRK100NSE-launchedIFRAn-Update28082009

Likewise, RBI and SEBI issued guidelines for exchange-traded currency futures in India in August last year. Accordingly, three stock exchanges were permitted to start trading in this derivative product.
TO KNOW MORE ABOUT CURRENCY FUTURES, JUST CLICK:
http://www.scribd.com/doc/21686968/Currency-Futures-in-India-status-Check-AfterOne-Year-Vrk100-27102009

However, surprisingly, RBI has come out with new financial instruments that are expected to be launched in the next few quarters. They are:
Final guidelines on repo in corporate bonds will be issued by end-November 2009. Draft guidelines have already been issued. To introduce plain vanilla over the counter (OTC) single-name credit default swaps (CDS) for corporate bonds for resident entities subject to appropriate safeguards. To begin with, all CDS trades will be required to be reported to a centralised trade reporting platform and in due course they will be brought on a central clearing platform. At present, issuance of non-convertible debentures (NCDs) with maturity of less than one year is not subjected to regulation by the SEBI or the Government of India. Now it is decided that Reserve Bank may frame regulations on issuance of NCDs with maturity of less than one year, as they fall under the definition of ‘money market instruments’ of Chapter IIID of the Reserve Bank of India (Amendment) Act, 2006. Accordingly, draft guidelines are being formulated by RBI which will be placed on the Reserve Bank’s website by end-November 2009 for comments/suggestions. Separate Trading for Registered Interest and Principal of Securities (STRIPS): Banks will be permitted to strip/reconstitute eligible securities held in their held to maturity (HTM)/available for sale (AFS)/held for trade (HFT) portfolios. Accordingly,STRIPS will be launched, as scheduled, during the current financial year

Rama Krishna Vadlamudi, MUMBAI.

October 28th, 2009

Page 8 of 12

The FRBs will henceforth be issued by way of ‘price-based’ auction as against the earlier ‘spread-based’ auction. Accordingly: floating rate bonds will be issued during the current financial year depending upon the market conditions and market appetite. It is proposed to permit the three recognized stock exchanges to trade currency futures in three more currency pairs namely, Euro-INR, Japanese Yen-INR and Pound Sterling-INR; in addition to US Dollar-INR which has already been permitted since the introduction of currency futures in

August 2008.
Draft guidelines on Forex, Commodity and Freight Derivatives will be issued by the end of November 2009 for wider dissemination and comments/views

6. IMPACT OF THE POLICY MEASURES
BOND MARKET:
The initial reaction in the bond market was positive as SLR was raised by 100 basis points to 25 per cent. As a result, the benchmark 10-year yield has softened by up to 10 basis points and the closing yield was 7.34 per cent on the announcement day. At this point of time, it is comforting to note that RBI has not taken any policy measures to suck out liquidity from the banking system even though RBI has clearly indicated that it would have to increase its policy rates at some point of time in future. RBI seems to be giving more importance to continue with the stimulus for GDP growth in the economy. As such, it has not undertaken any key measures except raising the SLR. The biggest beneficiary of the SLR increase will be the Government of India. Overall, the 10-year benchmark yield may remain between 7.20 and 7.50 per cent in the next few months before any further policy measures are undertaken by RBI. EQUITY MARKET: Equity market has reacted negatively to the RBI policy. As RBI has increased risk weights for loans to commercial real estate sector, there was heavy selling in real estate stocks. Bank stocks too reacted negatively as RBI has proposed to increase the NPA loan coverage ratio to 70 per cent and banks have to achieve this limit by September 2010. As suggested by existing data, it appears this measure will severely impact banks like, State Bank of India, ICICI Bank and Canara Bank whose coverage ratio at present is between 40 to 50 per cent. However, there is a feeling in the market that RBI may dilute this norm in future or may postpone the implementation of this policy action. October 28th, 2009

Rama Krishna Vadlamudi, MUMBAI.

Page 9 of 12

Overall, rate sensitive sectors, like, automobiles, banks and real estate sector will be negatively impacted by the monetary policy stance, which might turn hawkish in the next few months depending on the inflationary pressures and other aspects, like GDP growth and industrial production data. However, it should be noted that the impact will be different from sector to sector and from company to company. While impact on banking sector may be less (as they are expected to maintain their net interest margins), debt-ridden real estate sector may be hit more severely. MONEY MARKET: There was not much reaction in the money market after the RBI’s review. The call money and CBLO rates have remained at the same levels as before. However, going forward, there will be some impact. From next month onwards, CBLO will be subjected to CRR and as such the volumes in the CBLO market may get impacted in future. As of now, there is no change in CRR. However, when the CRR is hiked, the money market rates will go up. Moreover, market will react to the proposed regulations on one-year non-convertible debentures below one year; issue of floating rate bonds; and introduction of final guidelines on repo in corporate bonds. These developments are worth watching in the money market going forward. Call money rates at present are between 3 and 3.30 per cent. CURRENCY MARKET: The initial reaction in the forex markets was a bit positive for the rupee appreciation. However, after the stock market indices started falling heavily, the rupee began to depreciate and breached the 47 level and subsequently ended at 46.91 on Tuesday.

7. RBI’s CONCERNS
INFLATION: As inflation based on consumer price index is still in double digits, RBI has expressed its concern about inflationary pressures. The present CPI inflation is induced by supply side pressures and a weak monsoon exacerbated by crop damage due to floods in certain parts of the country. There is not much RBI can do to the supply side pressures. Taking every thing in to account, RBI has given an inflation (WPI) target of 6.5 per cent by March 2010. Ironically, RBI has not raised CRR even though it expects inflation to rise to 6.5 per cent in the next five months from the present level of 1.2 per cent. The Governor’s explanation is that he does not want to give any wrong signals to the economic agents in the country as far as growth stimulus is concerned.

Rama Krishna Vadlamudi, MUMBAI.

October 28th, 2009

Page 10 of 12

BANKS’ INVESTMENTS IN MUTUAL FUNDS: RBI is concerned about the indirect flow of liquidity that is taking place from banking sector to the corporate sector through the mutual fund route. For the quarter ended September 2009, the banking sector had invested around Rs 1,60,000 crore in different mutual fund schemes like income, liquid and money market. The mutual funds, in turn, are understood to have lent this money to the commercial or corporate sector. Due to regulatory arbitrage of taxes, banks have been investing in mutual fund products substantially. There is a concern on the circularity of liquidity in the system. Keeping this in view, RBI has advised banks to form governance norms for governing their investments in mutual funds. Some pundits argue that mutual funds should not be an outlet for banks to park their resources. THE CURIOUS CASE OF ASSET PRICE INFLATION: One surprising element in the policy document is the RBI’s observation on Asset Price Inflation. In the policy review, RBI asserts that asset prices have risen sharply in the recent period. It further claims that after showing some correction in the latter part of 2008 and early part of 2009, real estate prices have risen significantly in major cities. The curious case here is that it has not given any specifics in this regard. It is interesting to note that RBI’s policy documents are usually littered with enormous data to buttress their arguments and opinions/views. But in the case of this so-called asset price inflation, RBI is silent and has not given any data.

This entire analysis is meant to be politically correct! If you want to know my real views on RBI’s actions and inactions, please wait for a day or two and watch my POLITICALLY INCORRECT, DIABOLICAL and EXPLOSIVE ANALYSIS of RBI’s poor record of reining in inflationary expectations in the economy and how RBI Governor is acting as THE BEST MONEY MANAGER of the Government of India…

Rama Krishna Vadlamudi, MUMBAI.

October 28th, 2009

Page 11 of 12

8. THE CONTROVERSY ABOUT RAISING THE HTM LIMIT
Since the middle of September 2009, the bond markets were agog with rumours that RBI would increase the HTM – Held to Maturity – limit from the existing 25 per cent of demand and time liabilities in order to facilitate the government’s heavy borrowing programme. In its review, RBI has given a very funny reason why it was not raising the HTM limit. Interestingly, RBI has taken more than a month to express its categorical view on raising HTM limit. In the meantime, bond market witnessed some wild movements. The 10-year benchmark moved from 7.45 per cent yield in the first week of September 2009 to a low of 7.00 per cent in the third week of September 2009. After a few weeks of euphoria about the impending RBI’s relaxation of HTM limit, the bond market seems to have realized its folly and the yields started inching up again with the 10-year benchmark government security yield hardening to 7.50 per cent a day before the RBI’s second quarter review. Is there any method in this madness? Why has the RBI taken more than six weeks to give its categorical view after both the Governor and a Deputy Governor had gone on record saying that the RBI was considering raising of the HTM limit? Why has the RBI encouraged unnecessary and highly avoidable speculation in the bond markets? This is highly paradoxical on the part of RBI to actively stoke speculative elements in the bond markets. Is this just a ruse by RBI to facilitate Government’s heavy borrowing programme? And who has benefited from this speculation? Is it the banks, primary dealers or Government of India? May be, we would never know the answers for this piquant situation. Another interesting piece of information, readers would like to know is that the RBI Governor boasts in his review that RBI has raised money at an average cost of only 7.14 per cent (for Central Government’s borrowing from April 1st up to October 26th, 2009) despite hefty and record Government borrowing programme and the Governor further claims that this average yield is lower than the average cost of 8.81 per cent for the corresponding period of the previous year. Wow!

Rama Krishna Vadlamudi, MUMBAI.

October 28th, 2009

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