In the second quarter review of the Monetary Policy, the Reserve Bank of India (RBI) indicated a lower growth projection of 5 per cent for FY14 compared to its previous baseline forecast of 5.5 per cent, while expressing concerns regarding the inflation trajectory.

It indicated that headline wholesale inflation may exceed the present 6.5 per cent for much of FY14, effectively raising its March 2014 inflation projection from 5 per cent,, while retail inflation may remain elevated at around 9 per cent.

With conflicting policy prescriptions arising from the prevailing growth-inflation dynamics, the RBI chose to focus on curbing inflationary expectations by hiking the repo rate by 25 basis points, in line with our expectations.

Restoring normalcy

A decline in volatility in the forex markets benefiting from the swap windows for FCNR(B) deposits, and overseas borrowings of banks and oil marketing companies (OMCs), prompted the RBI to reduce the marginal standing facility (MSF) rate by 25 basis points. With this, the RBI further unwound the exceptional measures introduced since July 2013 and brought the repo-MSF corridor back to the normal 100 bps.

At the same time, to assuage liquidity concerns at affordable rates to productive sectors, the RBI also increased the magnitude eligible under term-repo to 0.5 per cent of NDTL of the banking system.

The reduction in the MSF rate and hike in the term-repo cap to 0.5 per cent of NDTL are expected to contribute to a softening of short-term rates, and a revival of the commercial paper market. This would dampen FY14 credit growth to around 14-15 per cent from the current 18 per cent.

Bonding with market

While the RBI refrained from issuing an explicit guidance, it indicated that it would closely monitor inflation risks and be watchful of evolving growth dynamics.

Based on the anticipated inflation trajectory, the RBI is expected to increase the repo rate by a further 25 basis points prior to March 2014, but provide liquidity using other tools at its disposal.

The RBI may choose to observe the extent of volatility, post the closure of the swap windows, particularly for the OMCs, and subsequently raise the cap of 0.5 per cent of NDTL on borrowings at the repo rate, to further unwind the exceptional measures.

The move to introduce cash-settled interest rate futures is welcome as it will provide market participants with another tool to hedge or take strategic trading positions. This, in conjunction with the credit enhancements permitted in corporate bonds, could provide a further fillip to the development of the bond markets.

The planned introduction of securities linked to consumer price index for the retail investors should slowly help in improving the financial savings matrices. With the RBI continuing to strengthen the financial system, there could be a slew of guidelines in the near-term.

( The author is MD and CEO, ICRA .)

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