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September 2012

The RBI kept policy rates on hold in the Mid Quarter Review on 17th September while reducing the Cash Reserve Ratio by 25bps. The recent government initiatives to address the fiscal situation and improve the investment climate had led to some anticipation in the market on a repo rate cut. In the context of the recent elevated headline inflation numbers and the twin deficits on the current account  and fiscal side, the RBI has been constrained in addressing the growth risks through aggressive monetary policy actions. The guidance has interestingly acknowledged that Monetary policy has an important role in supporting the growth revival. The CRR reduction has to be seen in the context of recent actions from the RBI to ensure adequate liquidity in the banking system. The liquidity conditions which have improved substantially in the recent weeks could incrementally be under pressure in the second half of the fiscal year (Starting October)  on account of seasonal factors such as currency withdrawals from the banking system and relatively higher credit demand. In this context, the CRR reduction would enable primary liquidity to the extent of Rs 170 bn.

We anticipate that the RBI could follow up the CRR reduction through additional OMO transactions in the coming months to ensure that liquidity conditions do not stress the banking system and credit flow to productive sectors is maintained. In the event of further reform initiatives from the government in the coming months, the market would position for the possibility of a rate reduction in the policy review in October. The continuation of reform initiatives would be positive for the INR and rates.

Given the prospect of RBI liquidity infusion measures and the possibility of OMO’s and also the reduced supply pressure in the second half, government bond yields are likely to be well supported. The recent fiscal measures could result in the  markets positioning for a rate reduction in the policy review in October.

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