By Sukumar Rajah, Managing Director and Chief Investment Officer of Franklin Templeton India AMC Ltd.

At the end of January, India's central bank, the Reserve Bank of India (RBI) held its quarterly policy review. The RBI left the repo and reverse repo rates unchanged, but increased the cash reserve ratio (CRR) by 75 basis points to 5.75%. It increased its estimate for inflation at the end of March 2010 from 6.5% to 8.5%, as well as its forecast for gross domestic product (GDP) growth for the fiscal year ended March 2010, from 6.0% to 7.5%. Estimates for money supply growth and non-food credit growth were revised downward¹.

In its previous quarterly policy review, the RBI increased the statutory liquidity ratio (which restricts banks' leverage in pumping more money into the economy), rolled back various liquidity measures and tightened non-performing asset norms for banks. In this context, we see the CRR hike as part of the RBI's efforts to manage liquidity and inflation expectations, trying to prevent asset bubbles without derailing growth momentum.

The downward revision in credit growth was also much according to expectations, as this number has remained muted in recent quarters due to the availability of funds from non-banking and external sources. Until there is a sharp change in global liquidity and risk perceptions, this moderation could continue. The CRR hike is expected to remove approximately Rs. 360 billion from the system¹. This, along with the possibility of liquidity tightening in February and March, as well as divestment plans, could further tighten short-term liquidity.

Overall, the RBI's policy was focused on anchoring inflation expectations, actively managing liquidity to meet credit demands, and maintaining an interest-rate environment that seeks price stability and supports growth. The RBI indicated that its stance has changed from 'managing the crisis' to 'managing the recovery'. It also emphasized the need to lower the fiscal deficit and that an exit from easy monetary policy could not be effective without a decrease in government borrowing. The RBI's statements indicate that it is likely to wait for the unwinding of fiscal stimulus in the upcoming Union Budget before implementing any additional measures. Food price inflation due to supply constraints must clearly be addressed, and the government has yet to articulate a clear path for fiscal consolidation.

We view the RBI's latest policy announcements as a natural progression of the policy normalization that is taking place the world over, albeit at a faster pace in emerging markets. Monetary policy trends continue to be driven by the difference in economic growth rates witnessed by various countries-central banks in emerging markets, especially in Asia, are clearly on the tightening path, while those in developed economies look likely to maintain the status quo. Recently, the People's Bank of China increased reserve requirements for its banks and Taiwan increased overnight lending rates. Meanwhile, sovereign credit risks have become a new focus given the high levels of deficits across the globe.

Percentage Change in Indian Bank Credit 5 January 2007 – 15 January 2010

Sources: Citigroup and RBI, 15 January 2010

¹ Source: Reserve Bank of India, Third Quarter Review of Monetary Policy 2009-10, 29 January 2010