Rama Krishna Vadlamudi, HYDERABAD November 3, 2010

As expected by the markets, the Reserve Bank of India – in its second

quarter review of the Monetary Policy announced on November 2, 2010 – has
raised both the Repo and Reverse Repo rates by 25 basis points each from
6.00 per cent to 6.25 per cent and from 5.00 per cent to 5.25 per cent
respectively in order to contain the stubborn inflationary pressures in the
economy. However, the RBI has indicated that it may not raise interest
rates further for the next few months provided inflationary pressures ease
in future. RBI has been trying to maintain a fine balance between reining in
inflation while keeping growth drivers of the economy intact. It remains to
be seen whether the RBI will succeed in its stated objectives.

The RBI has introduced a new concept of Loan-to-Value (LTV) ratio while
financing housing loans. From now onwards, banks cannot lend more than 80
per cent of the value of the house. Provisioning for housing loans based on
teaser rates has been increased from 0.40 per cent to 2.00 per cent. Risk
weights for residential housing loans of Rs 75 lakh and above has been
increased to 125 per cent making such loans costlier for borrowers. This may
further squeeze the real estate sector. Minimum threshold for sending
RTGS remittances has been increased to Rs 2 lakh from Rs 1 lakh.

Let us examine the Monetary Policy Review decisions and their implications.
 Rama Krishna Vadlamudi, HYDERABAD November 3, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com

Monetary Measures undertaken by RBI on November 2, 2010:

1) LAF-Repo Rate is increased by 25 basis points to 6.25 % wef Nov 2, 2010
2) LAF-Reverse Repo Rate is hiked by 25 basis points to 5.25 % wef Nov.2, 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 %

Containing real estate sector:

o RBI has introduced a new concept of Loan-to-Value (LTV) ratio for housing loans
which is put at 80 per cent. From now onwards, banks cannot lend more than 80
per cent of the value of the house.
o Standard Asset Provisioning for housing loans based on teaser rates has been
increased from 0.40 per cent to 2.00 per cent. Housing Loans with teaser rates
are the loans that are offered at a comparatively lower rate of interest in the
first few years, after which rates are reset at higher rates.
o At present, the risk weights on residential housing loans with LTV ratio up to 75
per cent are 50 per cent for loans up to Rs 30 lakh, and 75 per cent for loans
above that amount. In case the LTV ratio is more than 75 per cent, the risk
weight of all housing loans, irrespective of the amount of loan, is 100 per cent.
Accordingly, it is decided to increase the risk weight for residential housing
loans of Rs 75 lakh and above, irrespective of the LTV ratio, to 125 per cent.

Other Measures:
o RBI will put draft guidelines on Licensing of New Banks by end-January 2011
o RBI has exhorted the Banks to gear up for the challenges posed by introduction
of IFRS with effect from April 1, 2013 and implementation of Basel II and III
norms. RBI has advised the banks to undertake capacity building exercise in
right earnest and in a time bound manner.
o The work relating to introduction of Exchange-traded interest rate futures
(IRFs) on 5-year and 2-year notional coupon bearing Government of India
securities and 91-day Treasury Bills in is progress
o The Final guidelines on introduction of Credit Default Swaps will be finalized by
RBI shortly
o RBI will issue Final guidelines on OTC Forex Derivates by end-November 2010
o Changes have been proposed for capital adequacy norms for Financial
Conglomerates
o The work relating to the introduction of a holding company structure together
with the required legislative amendment/framework is in progress
o The minimum limit for RTGS transactions is hiked from Rs 1 lakh to Rs 2 lakh
o It is planned to roll out cheque truncation system (CTS) in Chennai in March
2011. This is second CTS after New Delhi where it was introduced in Feb. 2008.

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 Rama Krishna Vadlamudi, HYDERABAD November 3, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com

Impact of RBI’s ‘baby steps’ 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 6.00% by Nov.10 100

Repo Rate-LAF 4.75% in Mar.2010 6.25% in Nov.10 150
Reverse Repo rate-LAF 3.25% in Mar.2010 5.25% in Nov.10 200

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

RBI has been raising interest rates since the beginning of this year in what itself calls as
‘baby steps’ – meaning they have been increasing the rates in small doses of 25 basis points
each without giving any shocks to the markets. The rate increases have no impact on the
stock markets except for the stocks in real estate sector. While RBI increased CRR by 100
bp and repo rate by 150 bp in the last nine 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 more than 25 per cent. Due to large portfolio inflows pouring in
through the Foreign Institutional Investors (FII) and other factors, India’s stock markets
have remained buoyant in this calendar year. As per SEBI data, FII inflows into the stock
market are around USD 25 billion during the 2010 calendar year.

Though RBI raised repo and reverse repo rates, the Bond market has reacted positively to
the news with the yield on benchmark 10-year Government Security falling to 7.97 per cent
on November 2, 2010. It may be noted that this yield had gone up to as high as 8.14 per
cent on October 20, 2010. The optimistic reaction from the Bond market is due to the fact
that RBI has indicated that it may not raise interest rates further for the time being
depending however on the fulfillment of its expectation of softening inflation in future.

Through the auction of 3G and Wireless Broadband telecom spectrum in this financial year,
the Government of India (GOI) has realized windfall revenues of around Rs 1,10,000 crore.
This is Rs 75,000 crore more than the budgeted figure. Tax collections have been robust
this year. The finances of the Government have further been bolstered by the inflows
through disinvestment of small stakes in public sector undertakings, like, Coal India, NTPC,
NMDC, etc. In view of this, GOI has announced that it would cut its market borrowings by
Rs 10,000 crore in the second half of fiscal 2010-11. Fiscal deficit may remain under control
in 2010-11. All this augur well for the Bond market in the short-term. However, one-time
windfall revenues should not lull the GOI into complacency.

Page 3 of 5
 Rama Krishna Vadlamudi, HYDERABAD November 3, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com

Banks may not immediately raise their lending rates. They have already hiked their
benchmark prime lending rates (BPLRs) by 25-75 basis points in the past two moths in
reaction to the consistent hike in RBI policy rates. Base Rates too have been increased by
10-50 basis points. However, banks may raise housing loan rates as RBI has tightened the
loan provisioning and capital adequacy norms. After the announcement of the second quarter
review, IDBI Bank has resorted to upward revision in both the lending and deposit rates.

Growth drivers of Indian Economy:

o Domestic consumption is fuelling India’s GDP
o Strong fundamentals of Indian companies
o Good monsoon is likely to boost agriculture production this year
o While RBI has projected a growth of 8.5 per cent for India’s GDP in 2010-11,
CRISIL has put the number at 8.2 per cent and CMIE at 9.2 per cent
o Consumer durables and Automobile sectors have been growing very strongly
o Savings rate of around 35 per cent in the household sector

Concerns for the markets in future:

o Strong FII inflows, which are volatile in nature, into the stock market
o Inflation continues to be the nemesis for the RBI as well as GOI
o The ballooning food inflation is due to structural issues in the economy and the
RBI’s measures may not help very much
o The ever-expanding current account deficit (CAD) may not be a good sign for
the economy. It is said that any CAD beyond 3% of GDP is not sustainable.
o Export sector is weak due to a combination of factors like, sluggish growth in
developed markets, appreciating rupee, issues surrounding competitiveness of
the India’s export industries, etc
o The rising interest rates may impact the capital expenditure plans of the India
Inc which may not be good for the capital goods sector
o The Government too has slowed down infrastructure development despite
several noises to the contrary
o RBI has expressed its concern about the rising Asset prices – stock indices,
residential housing and gold

Notes:
FII-Foreign Institutional Investor
IFRS-International Financial Reporting Standards
IIP-Index of Industrial Production
LAF-Liquidity Adjustment Facility of the RBI
LTV-Loan-to-Value Ratio
RBI-Reserve Bank of India
RTGS-Real Time Gross Settlement
Disclaimer: Views of the author are personal.
----------------------------------------------------------------------------------------------

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 Rama Krishna Vadlamudi, HYDERABAD November 3, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com

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