Indian Economy : RBI Pauses On Rates And Moves On Bank Licenses

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(London – FCO analysis):

AN EXTENDED PAUSE: RBI maintains a cautious outlook on growth, expecting only a modest recovery in growth from a little below 5 per cent in 2013-14 to 5 to 6 per cent in 2014-15, with downside risks to the central estimate of 5.5 per cent. Despite the softening of inflation, the RBI warns of potential upside risks to its 8% January 2015 CPI inflation ‘target’, emanating from the possibility of a poor monsoon, hikes in administered prices and global commodity prices. It rules out the possibility of any rate cuts on what it terms a transient softening of inflation, while remaining vigilant on upside pressures.

DEVELOPING A TERM REPO MARKET: In line with the recommendation of the Urjit Patel committee on the monetary policy framework, the RBI is slowly charting a shift from the provision of liquidity through overnight repos to 7-14 day term repo. Through the repo facility the RBI provides liquid funds to banks against collateral of government securities. Liquidity provided under 7-day and 14-day term repos has been increased from 0.5% of banking system liabilities to 0.75%, while liquidity provided under overnight repos has been reduced from 0.5% of banking system liabilities to 0.25%. The RBI hopes to improve monetary policy transmission across the interest rate spectrum through the shift to term repos . It would also provide impetus to banks for engaging in term transactions in the market and evolve market-based benchmarks for pricing various financial products.

CURBS ON SHORT TERM FOREIGN INVESTMENT: After the summer of 2013, the RBI remains focused on attracting long term capital flows. Foreign investment will henceforth be permitted only in dated securities of maturity one year and above. Currently foreign investors are allowed to invest US$5.5bn in Treasury bills; existing investments in T-bills will be allowed to taper off. The total foreign investment limit in Government securities remains unchanged at US$30bn.

ENCOURAGING ONSHORE HEDGING: In order to enhance hedging facilities for foreign investors in debt instruments, it is proposed to allow hedging of coupon receipts falling due during the next 12 months. Discussions are also on with SEBI, the securities regulator, to allow foreign investors to hedge their currency exposure through trade in currency futures.

AWARD OF BANK LICENCES: In February 2013 applications were invited for new bank licences and more than 25 firms had applied. An advisory committee headed by Bimal Jalan, former RBI Governor had made its recommendation in February 2014. However since India is currently in the election phase the RBI had sought the approval of the Election Commission (EC) to announce the licences. With approval from the Election Commission, the RBI has now announced “in principle” approval to two firms, infrastructure finance company IDFC and microfinance firm Bandhan Financial services. The Indian postal department, which accepts savings deposits was also an applicant; the committee has recommended that the application be considered separately in consultation with the government.

DIFFERENTIATED LICENSING: The RBI will also soon begin work on the framework for on- tap licensing (continuous licensing) and differentiated licensing. UK financial services could potentially benefit from the differentiated licensing regime. The RBI notes that its approach in announcing bank licences has been “conservative” and believes that some of the entities who did not qualify in this round for a fully-fledged banking licence could apply in future rounds or for differentiated licences. The RBI has said it is also open to bank mergers provided competition and financial stability are not compromised.

BASEL III DEADLINE EXTENDED: India has been ahead of the game on BASEL III, issuing final guidelines on capital requirements in May 2012 and a discussion paper on the counter – cyclical capital buffer in December 2013. However on account of the stress in the Indian banking system owing to the cyclical downturn in asset quality, the deadline for full implementation of Basel III in India has been extended by a year to March 2019 from March 2018 . The RBI is expected to issue guidelines with respect to the BASEL III – Liquidity Coverage ratio by May 2014.

FIVE PILLAR REFORM AGENDA: Governor Rajan on taking office committed to five pillars of reform. His five point agenda was focused on 1) Monetary policy framework 2) Banking structure reform 3) deepening financial markets 4) Financial inclusion 5) Strengthening asset recovery. The policy statement was essentially a self appraisal showing progress against stated objectives. Reactions

Most analysts expect an extended pause on rates from the RBI, with hawkish undertones. After the announcement of bank licences , shares in many small and medium sized banks gained on expectations that the new banks may opt for the acquisition route to establish their presence . However the likelihood of mergers in the short term is limited. The firms which have received approval have been given 18 months to comply with RBI requirements.

Comment

Foreign holding in new banks will be capped at 49% for the first five years after which it can increase to 74% in line with existing policy. IDFC is a listed company and steps to curb the foreign investment limit were initiated in August 2013, after the application was submitted, in order to comply with the regulations governing new banks.

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