Monetary Policy Announcement and its broader implications

The Monetary Policy announced by the RBI on 08th February was largely along expected lines. One needs to understand the context in which the policy was announced. On the one hand, the Indian economy is just about emerging from the cash shortfall caused by the demonetization. On the other hand, inflation continues to stay under control and IIP and core sector are showing green-shoots of recovery. The global scenario is the bigger question mark. BREXIT is raising serious questions over the sustainability of the common currency model while the UK still does not have clarity on its trade strategy post BREXIT. Above all, the US is increasingly making protectionist noises even as Indian companies are already under pressure due to recent measures like H1-B visa restrictions, immigration checks and a likely border tax on outsourcing. It is in this highly charged atmosphere that the Monetary Policy was announced by the RBI…

Key takeaways from the Monetary Policy and its implications…

  • The Monetary Policy Committee (MPC), took a decision in its 2-day meeting to keep repo rates unchanged at 6.25%. This leaves the reverse repo rate unchanged at the original level of 5.75% and the MSF and Bank rate unchanged at the 6.75% level. It needs to be remembered that the Bank rate and the Reverse Repo are fixed at a 50 bps spread above and below the repo rate respectively and hence are derived rates.
  • The RBI has also chosen to keep the cash reserve ratio (CRR) unchanged at 4% and the statutory liquidity ratio (SLR) unchanged at 20.75%. With the glut of deposits in the banking system after the demonetisation exercise, the RBI had no requirement to really tinker with either of these rates as liquidity was already available in abundance in the system.
  • The full year GDP estimate of the RBI was the big surprise in this policy announcement. The market consensus estimate was that the RBI may project GDP growth of just 6.2% for the fiscal year 2016-17. The RBI has projected full year GDP at 6.9%, which is very close to the CSO estimates of 7% in the advance estimates of GDP announced in early January 2017.
  • There is a very interesting inference that can be drawn from the RBI GDP growth projections. The original CSO advance estimates were made without considering the impact of demonetization, whereas the RBI estimates have factored the impact of demonetization. One can safely conclude that either the impact of demonetization is likely to be very limited or the aberration will be compensated for in the fourth quarter of the fiscal year 2016-17.
  • The policy has identified inflation as the first major reason for not cutting repo rates. Although the CPI inflation has stayed below the RBI mandated long term inflation target of 4% in the last couple of months, RBI sees 3 reasons to worry. Firstly, the non-food inflation at 4.9% continues to be sticky led by housing and healthcare. Secondly, the base effect may have distorted the actual inflation in the last 2 months. Lastly, oil prices could trend higher if the OPEC continues its quotas and that can drive up inflation significantly.
  • The second reason proffered by the RBI to not cut repo rates is that a lot of rate cut has already happened from an end-customer point of view. Banks flush with deposits after demonetization, found their businesses in a piquant situation. They were paying interest on deposits but not earning on loans due to poor loan off-take. Obviously, SBI took the lead by cutting its MCLR by 90 basis points and most other banks followed suit. The net impact was that the eventual transmission of rate cuts to the end customer was more than the rate cuts implemented by the RBI since Jan 2015. This obviated the need for further rate cuts by the RBI.
  • The third reason why the RBI did not cut repo rates was that it needed to observe that growth was actually happening. Back in October 2016, the MPC in its minutes had explicitly mentioned that the rate cut was being implemented to spur growth. IIP, Core Sector and PMI-Manufacturing are beginning to show green-shoots of recovery. The time was ripe for the RBI to wait out a couple of months data of growth numbers to get a better understanding of the impact of lower rates on spurring growth in the key sectors of the economy.
  • Finally, the global state of flux also contributed to the RBI going slow on repo rate cuts. While the Fed did not tinker with rates in February, Janet Yellen has adopted a very hawkish language and that means one can expect at least another 2 rounds of rate hikes in 2017. RBI preferred to wait out the March Fed policy before taking a call on repo rates in April this year. The RBI also needs to ensure that any repo rate cut does not reduce the India-US yield spread to unsustainable levels. That will lead to further FPI outflows and India has already seen FPI outflows to the tune of $12 billion in the Oct-Dec 2016 quarter.

So where does that leave the outlook for repo rates in the full year 2017? We still believe that there is room for the RBI to undertake two rounds of repo rate cuts of 25 basis points each during the calendar year 2017. That would, of course, depend on the US Fed not getting too hawkish and aggressive on rate hikes during the year. But first, we will have to await the complete details of the MPC deliberations which will be published on February 22nd 2017. That will give a clearer indication of the road ahead!

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