India: Bigger monetary picture

•Keeping up appearances

The issue for tomorrow's monetary policy meeting is this: how to make it look like tightening when the real objective is to leave liquidity conditions little changed? One policy objective is to promote a recovery in bank lending, another is to maintain smooth government budget funding. In our view hiking the policy interest rate corridor (ie both repo and reverse repo)
accomplishes this. Reserve requirement hikes do not, after all why drain funds which might later need to be re-injected to 'smooth' interbank funding volatility. It turns out that whether it’s all rate hike or all CRR or a bit of both, say 25bp apiece (as we expect) is almost completely irrelevant. All that matters is the bark, the signal, because there's no real teeth to a policy
tightening at this stage anyway. For investors though monetary conditions are about to tighten up even if the RBI ducks it and does nothing tomorrow, here's how.

•Conditions matter

There is a difference between monetary policy and monetary conditions. It's conditions (namely demand) which is changing at the margin. Rewind back to the Lehman's bankruptcy and recall that the flight of foreign capital was matched almost one-for-one by a significant quantitative domestic monetary easing. After a temporary dip money growth hardly slowed (M3 and
adjusted money base have averaged 19-20% over last 12 months, chart 1). But demand collapsed along with confidence. That is what is now changing, and fast. As a consequence credit is already picking up. So all the unlent excess funds, so called 'liquidity' which has helped support equity valuations and keep short-term market rates low has now started to dwindle. This is
what is changing, irrespective of policy. Policy as usual coincides with this, but as we just explained credit growth just isn’t strong enough to justify a 'sledgehammer-nut' approach. Tomorrow policy will be one of many signals that tell investors conditions are tightening. Others to watch include: production & GDP, short money market rates, flatter yield curve, a peak-out
in our LEI (not yet, chart 2) and of course bank lending itself chart 3.

•Inflation

Rising inflation expectations are a great pretext to use to hike rates, but
ultimately we suspect a more modest rise in monetary-driven inflation in
2010-11of perhaps 1% to 5.5% - absent food effects. Using our UBS version
of the CPI we expect headline inflation to remain elevated till May, after
which it slows (chart 4). In this chart we simply assume an average monthly
rise equivalent to that over 2004-07. Please see our recent articles on
inflation Emerging Economic Focus: "India's Hard Choices, 4th Jan 2010",
Asian Economic Perspectives: "The Inflation Enigma Explained", 26th Nov
2009.