Implications of the RBI Monetary Policy for markets

There was a crescendo of excitement that was built around the Monetary Policy announcement. In the last few days the opinions were increasingly divided. The status quo camp believed that there would be no rate cut due to uncertainties over inflation and the Fed meeting in September. The rate cut camp (including the likes of Moody’s) believed that a 25 basis point rate cut was likely due to low growth as well as the Federal Reserve Board (FRB) minutes hinting at postponing the rate hike to December. In the end the status quo camp prevailed. Now for the highlights of the monetary policy announced by the RBI on 04th August 2015!

Highlights of the Monetary Policy – August 04, 2015

  • The repo rate was kept unchanged at 7.25%
  • The Cash Reserve Ratio (CRR) was kept unchanged at 4%.
  • The RBI has once again raised concerns over non-transmission of rate cuts by banks
  • Consensus reached on rate-setting panel
  • RBI retails growth target of 7.5% for the fiscal year 2015-16
  • Capital infusion into PSU banks will assist in transmission of rate cuts more effectively
  • Consumption demand is picking up in urban areas
  • Global markets, especially exports, remain weak.

Why the rates were kept constant

There were possibly 2 key reasons for the rates to be kept constant in the monetary policy. Firstly, there is the huge uncertainty on the inflation front. In the months of July and August the inflation number is likely to be low due to the base effect. This is not sustainable and is likely to go up again in September. Secondly, the RBI is still not satisfied with the extent of rate cut transmission by banks. Sample this! Since the beginning of the calendar year 2015, the RBI has cut repo rates thrice in tranches of 25 basis points each. Out of this 75 basis points cut in rates, only 30 basis points have been passed on by banks to the end customer. Therefore, the RBI believes that the purpose of rate cuts is getting defeated.

Combining recapitalization and transmission

The RBI has expressed its view that for transmission to happen to the fullest extent, the recapitalization of banks is a must. This problem is more acute in case of public sector banks. Due to high level of NPAs and low Tier-I capital, they are not able to transmit the benefit of rate cuts to the end customer. The high NPAs are adding to costs of banks and hence the rate cut by RBI is just giving them enough breathing space to survive. Rate cuts are therefore getting difficult. Additionally, most PSBs are starved for capital and that is constraining their loan book. Now the government has drawn up a plan to recapitalize PSBs through a Rs.70,000 crore infusion, it will synchronize better with rate cuts and a more efficient transmission mechanism.

Waiting for the September effect

The next monetary policy is schedule on September 29, 2015. The RBI may consider a rate cut in this particular policy; at least that is the indication that one gets. IIP numbers have been quite poor and core sector growth has been consistently bad. Both these factors call for a rate cut. But there are two key events in September. Firstly, there is the base effect of inflation. The base effect is likely to keep inflation low in July and August. With the base coming back to normal in September, it will give a clearer idea of the actual level of sustainable inflation. This will help the RBI to calibrate its monetary policy better. Secondly, there is the Fed meet that is scheduled in September. The thinking of the Fed is not very clear at this point of time but it is believed that they may want to wait till December for a confirmation that positive US data is sustainable. By September 29, the RBI will have clarity on both these issues. This will enable them to calibrate their monetary view better.

The long and short of the policy

The RBI governor has played it safe ahead of a plethora of uncertain events; and rightly so. A status quo in this policy gives him time till the end of September to evaluate the twin factors of the inflation base effect as well as US Fed rate decision. Moreover, the RBI governor has also hinted at a consensus with the government of India on the subject of the formation and structure of the Monetary Policy Committee (MPC). It is highly likely that effective the next policy on September 29, the MPC may play a pivotal role in rate decisions. That will have to wait till the end of next month!

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