The Monetary Policy Committee (MPC) decided unanimously to leave the repo rate unchanged in the first policy review for fiscal year 2018 (FY18). This was a foregone conclusion, with the monetary stance having been altered to neutral from accommodative in February 2017, and MPC’s focus on bringing Consumer Price Index-based inflation to 4% in a durable manner.
The inflation risks highlighted by MPC, such as the impact of monsoon dynamics on food inflation, increased allowances related to the seventh pay commission, one-off impact of the goods and services tax (GST) and global reflation risks, lent a hawkish tint to the policy document, spurring a modest intraday rise in yields on government securities (G-secs). Moreover, the assessed trajectory of CPI inflation, which MPC expects would rise from 4.5% in the first half of FY18 to 5% in the second half of FY18, and the retention of the baseline growth forecast for FY18 at 7.4%, cemented the expectation that the repo rate would be kept on hold during 2017.
The more pressing issue to be addressed in the policy review was measures to manage the prolonged liquidity surplus. The Reserve Bank of India (RBI) halved the corridor of rates for the liquidity adjustment facility (LAF), to +/- 25 basis points from +/-50 basis points around the repo rate. A basis point is one-hundredth of a percentage point. This entails an increase in the reverse repo rate to 6%, and a cut in the marginal standing facility rate to 6.5%. Both of these are beneficial to the banks, as they would earn higher interest on excess liquidity offered under the overnight LAF in times of surplus, and pay a lower rate to obtain liquidity in phases of deficit.
RBI reiterated its stance of bringing systemic liquidity closer to neutrality, and indicated that it would use a mix of tools towards this end, including longer-term variable reverse repo auctions, operations under the Market Stabilisation Scheme, issuance of cash management bills and open market operations.
A portion of the surplus in systemic liquidity is likely to be structural and not frictional in nature, warranting more permanent measures of absorption such as open market sales of the central bank’s holdings of G-secs, which stood at Rs7.5 trillion on 24 March 2017. The market will await clarity on both the magnitude of open market operations, which are constrained by the size of RBI’s holdings of government securities, as also operational details for the proposed non-collateralized standing deposit facility, which would greatly augment the central bank’s liquidity management toolkit.
In line with Icra’s expectations, the central bank did not increase the cash reserve ratio (CRR) from the current level of 4% to absorb surplus liquidity in a more durable manner. This is likely to have come as a relief to the banks, as a higher CRR would add to their costs and also deter them from reducing the marginal cost of funds-based lending rates, constraining the transmission of past monetary easing.
MPC also commented on the scope for improved policy transmission, including to administered rates such as those on small savings schemes. Interest rates on such schemes were reduced by a limited 20 basis points for the quarter that started 1 April relative to the year-earlier quarter. This is far short of the decline in G-sec rates from March 2016 to March 2017, to which small savings rates are linked. In contrast, banks cut deposit rates across tenures by 80-200 basis points, sharper than the 50 basis points reduction in the repo rate during FY17, following the surge in liquidity. In the prevailing scenario, the stickiness in small savings rates has not hindered a fall in banks’ deposit rates, unlike in previous phases of tighter liquidity. The limited decline in small savings rates has also made them relatively more attractive, compared to bank deposits, a relief for the banking system that is flush with funds.
Given the liquidity surplus, liquidity management measures and rate action by RBI are likely to emerge as the key drivers of deposit rate cuts in the ongoing year. However, the relevance of timely changes in small savings rates for policy transmission would re-emerge as liquidity moves closer to neutrality.
Aditi Nayar is principal economist at Icra Ltd.