Implications of the Monetary Policy Announcement

The monetary policy announced on 09th August 2016 was significant in that it was the last policy that Dr. Rajan would be announcing. Dr. Rajan demits office in September and hence the next monetary policy on October 04th will be presented by the new RBI governor. The following were the key highlights of the monetary policy…

  • The repo rate under the LAF has been kept constant at 6.5%
  • The cash reserve ratio (CRR) has been maintained at 4% of net demand and time liabilities (NDTL)
  • The RBI has continued to infuse liquidity and has brought the deficit in the money market from 1% of NDTL to almost neutral level
  • This status quo on repo rates keeps the repo rates at 6% and the MSF and Bank Rate at the level of 7% since they are derived based on a 50 bps spread from the repo rate

Inflation was the major concern

The rate of inflation had gone up to a 15-month high of 5.77% in the month of June and that is too close to the upper end of the RBI’s comfort zone. Within the gamut of inflation, rural inflation has been running much higher than urban inflation and food inflation has been the key driver of higher inflation. While the monsoons this year have been good, the impact on the Kharif output is yet to be assessed. In addition, there are still major supply bottlenecks with respect to food grain distribution which will ensure that the inflation remains elevated.

Shift in focus to liquidity management rather than rate setting

Over the last few credit policies, the RBI has gradually underscored the importance of liquidity management over rate setting. The liquidity deficit was as high as Rs.250,000 crore last year which has been brought down substantially close to the level of 1% of NDTL. The target is to reduce this deficit in liquidity further to neutral level. During the current fiscal the RBI has already infused Rs.80,000 crore through OMO purchases and plans its next OMO on August 11th. Comfortable liquidity will ensure that yields at the shorter end of the yield curve will trend downwards.

Rate transmission remains the major concern for the RBI

The major concern for the RBI has been that since the beginning of January 2015 banks have only passed on 55% of the RBI rate cuts to the end customer. This has defeated the very purpose of the RBI cutting rates. The standard refrain of banks has been that they are preparing for a rainy day in case they are unable to handle the $20 billion FCNR redemption from September onwards. But the real reason seems to be that the rate transmission is unlikely to happen unless the NPAs of the PSU banks come under control.

RBI outlook for inflation and growth

The RBI has given a positive outlook for GDP growth, which it expects in the range of 7.6-7.7% with chances of an upward revision. Quarterly results, industrial output and export growth are all showing signs of momentum. However, the RBI sees upside risks to inflation in the current year. Apart from food inflation, the RBI also sees the liquidity infusion by OROP and 7CPC adding a few bps to inflation. Additionally, the implementation of GST will also result in service tax rate going up sharply building in a further 50 bps inflation. Already the inflation expectations measured by RBI at the retail end, seems to be indicating prospects of elevated inflation through the year.

Comfort level on the forex reserves front

The policy has also underscored the comfort level of the RBI on the forex situation. The RBI has managed a calibrated depreciation of the rupee. This has balanced the need for FPI and FDI flows as well as ensured that exporters do not lose their competitiveness in the light of the REER staying at elevated levels. The forex chest at $365 billion is already sufficient to cover 12 months of imports. With the RBI also resorting to intervention in the currency futures market, the redemption of FCNR deposits to the tune of $20 billion post September should not be a major hassle.

The idea of an MPC is yet to take full shape

The Monetary Policy Committee (MPC) was supposed to take the key decision on rates in this policy. However, the MPC is yet to be fully constituted. From the RBI side, the RBI Board has nominated Dr. Michael Patra for the MPC. In addition, the RBI governor and the deputy governor (monetary policy) will be automatically co-opted to the MPC. The remaining members will be nominated by the Finance Ministry. The MPC is supposed to create an institutional mechanism for rate setting, but for that we will have to wait for a future date.

Dr. Rajan’s unfinished agenda

Between now and the time Dr. Rajan demits office, there are 2 key regulatory changes that are expected. Firstly, the Peer-to-Peer (P2P) lending has become a big business in India today but it is still largely unregulated. The RBI proposes to bring in a key regulatory framework so that the P2P players are also brought into the financial market mainstream and regulated. Secondly, the governor also plans to announce measures to substantially broaden and deepen the debt markets. This is going to be inevitable if the government wants to use to use the debt route to raise funds for infrastructure.

As Dr. Rajan presented his last monetary policy, it must be surely said that he leaves the Indian economy and the financial system in a much safer and surer footing. The next policy announcement is expected on October 04th 2016.

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