RBI hikes CRR to 8% in two stages of 25 bps each effective from April 26 & May 10.

This is likely to drain out Rs185bn of liquidity from the system. Currently the liquidity in the system is comfortable as banks are parking money with RBI (average LAF absorption by RBI was Rs400bn during April 3-17, 2008 as against average daily injection of liquidity of Rs.274bn during March 17-31, 2008) hence liquidity wont be impacted significantly but after today’s run up in banking stocks some correction could be witnessed.

Year-on-year WPI inflation, which was 3.83 per cent on January 12, 2008, i.e., at the time of the announcement of Third Quarter Review, increased to 7.41 per cent on March 29, 2008 and remained at 7.14 per cent as on April 5, 2008 and its overall impact on inflation expectations requires to be monitored and moderated by RBI.

RBI in the third quarter review of monetary policy had stated that “liquidity management will continue to assume priority in the conduct of monetary policy. It was further stated that the liquidity conditions are being shaped by several underlying factors and their developments have implications for liquidity management going forward and warrant appropriate and timely action.” Taking the above factors into consideration RBI has taken the appropriate steps.

Our back of the envelope calculation suggests that NIMs are likely to be impacted by 2-4 bps and FY2009E PAT by 2-3%.

Banks currently don’t get interest on CRR hence the loss in income is due to funds that have to be set aside for CRR from excess liquidity parked in call money and other short term instruments. PSU banks could roll back PLR cuts announced in Feb 2008. However we feel all banks are likely to wait for the monetary policy to be over before taking any decision.