Key takeaways from the December 2016 Monetary Policy

The RBI monetary policy announced on December 07th 2016 had an element of surprise in that it maintained status quo on repo rates. Considering the low levels of inflation, weak growth and the side effects of demonetization, the markets were expecting a rate cut in the range of 25-50 bps. However, the RBI chose to err on the side of caution.. While the details of the deliberations of the Monetary Policy Committee (MPC) will be available on December 21st, there was virtual unanimity on the decision to maintain status quo on rates. Here are the key highlights of the monetary policy announcement…

Key Highlights of the Monetary Policy…

  • Repo rates were held static at 6.25%
  • Therefore the reverse repo rate also stays at 5.75% (repo-50 bps) and the bank rate stays at 6.75% (repo+50 bps).
  • The CRR remains at its old rate of 4% while the SLR remains at 20.75% of net demand and time liabilities (NDTL)
  • The RBI will continue to intervene in the money markets to balance liquidity imbalances and infuse or absorb liquidity when required
  • Incremental CRR of 100% which was imposed by the RBI on deposits between Sept 16th and Nov 11th, will be withdrawn effective December 10th

Low Inflation supported a rate cut, but RBI plays cautious…

Actually, inflation made a very strong case for a repo rate cut. CPI inflation came in at 4.20% for October with food inflation coming in at a low of 3.39%. This was a classic case for the MPC to consider a rate hike. However, the RBI has been sceptical about 2 key issues. Firstly, on the food inflation front, the overall basket excepting vegetables has shown a tendency to shoot on the upside. With the base effect waning, there is risk for food inflation.
Secondly, oil is a major worry for the MPC. Ever since the OPEC agreed to supply cuts at its OPEC meeting on November 30th, the price of Brent crude has rallied from $46/bbl to $54/bbl. This has the potential to create runaway inflation within India. More so, considering that oil prices have strong spill-over impact on both food and non-food inflation!

Growth has been tepid, and RBI believes it could get worse…

GDP growth over the last 2 quarters has been quite tepid as insufficiency of demand has spooked the GDP growth. With constraints on demand, industry is still operating at around 70% capacity and hence the scope for increase in credit off-take is also not too great. The RBI in its monetary policy statement has admitted that the Gross Value Added (GVA) will have to be downgraded from 7.6% to 7.1% for the fiscal year 2016-17. In fact, Fitch has already projected overall GDP growth for India at just about 6.9% for the full year. With weak PMI numbers on the manufacturing and services front, the RBI had a basket case to cut repo rates.

The RBI contention is that with the demonetization under way in India, any rate cut may not be of any use for improving growth. The issues are more on the demand side and that is likely to only pick up with a lag. In fact, the demonetization has created a liquidity crunch that has made domestic and business purchasers very cautious. That is one of the main reasons the RBI has refrained from rate cuts despite the weak growth indications. Also, the demonetization has created a huge imbalance in liquidity and that will take at least 6 months to self-adjust.

But the real story may have been about the Fed rate uncertainty…

On the Fed rates front, there is not too much uncertainty! There is almost a consensus on the street that the Fed will hike Fed rates by 25 basis points. But what would be of greater interest to analysts is the language and the trajectory of the Fed. Already PMI numbers for the US on manufacturing and services has shown a very sharp growth in the month of November 2016.  That means the language of the Fed could be hawkish and the trajectory of rate hikes may also be moved upward. Trump has already blamed the liquidity glut in the US economy for all its economic woes in the last 10 years. So, most likely, we may be staring at a 25 bps rate hike on December 15th with a hawkish outlook.

Why is this so critical? Firstly, this outlook will determine the direction of US 10-year benchmark bond yields. The gap between the Indian benchmark and the US benchmark for 10-year bonds has already contracted by over 200 bps in the last few months. The sharp sell-off in Indian markets in the month of November was largely predicated on this narrowing spread. November alone saw FII selling to the tune of $5 billion and as the gap narrows further, these outflows could become a deluge. That is a situation the RBI would want to avoid as they surely do not want a repeat of the foreign exchange crisis of 2013. That would have probably tipped the scales in favour of a status quo on rates.

Markets may be disappointed as it was expecting a rate cut, but that may not be too material. The MPC is right in that the spread needs to be maintained at healthy levels to entice foreign money into Indian paper. We will know the detailed deliberations of the MPC only when the minutes are released on December 21st. But for now the action shifts to the Fed policy in mid-December and India’s likely response in its next monetary policy on February 08th 2017.

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