In the short run, space for easing will open up only if fiscal consolidation satisfies RBI; over the medium term, it will depend on the inflation trajectory
Unchanged policy rates in the February policy was not a surprise to us because the focus was anyway on the forward guidance. The Reserve Bank of India (RBI) has not closed the space for further easing but it has quite understandably put some preconditions. While in the short run, any space for monetary easing will open up only if the quality of fiscal consolidation satisfies RBI, over the medium term, it will depend on whether the inflation trajectory significantly undershoots RBI’s current projections.
In FY17, government’s expenditure needs would be specifically focused on four different heads—implementing the 7th Pay Commission awards, maintaining high public capex, measures to stimulate rural demand and funds for recapitalizing banks. Besides, the fiscal roadmap suggests the government will have to cut fiscal deficit by 0.4% of the gross domestic product. Meeting these objectives will require new sources of revenue.
The government will have to look at four different strategies to augment revenues—tapping benefits of lower oil prices, pushing hard on divestment, raising service taxes and utilizing the potential of off-balance sheet entities like the National Infrastructure Investment Fund. We estimate that a $10 per barrel decline in oil prices leads to about 0.4% of GDP of positive impact on the fiscal deficit, if no benefit is passed on to consumers.
Under ideal circumstances, RBI would probably like to see the government meet its FY17 deficit target of 3.5% and focus more on improving quality of spending. However, given the peculiarities of this year’s budget, RBI has not linked its policy stance mechanically with any fiscal parameters. It could be a rather flexible interpretation of the budget numbers to figure out the government’s true intent and design the policy stance accordingly. We expect the scope for another 25 bps cut in the policy rate if the fiscal deficit does not disappoint.
In the latter part of 2016, the focus will shift towards meeting the baseline consumer price index (CPI) target of 5% by March 2017. While we are hopeful that global deflationary scenario and better food management by the government will help in achieving that, we will have to be watchful of the second round effects of the 7th Pay Commission awards.
The first round effect, primarily through higher housing inflation, could add about 50 bps to headline inflation (taking it higher than 6%) but the second round effects are much harder to estimate. The technical/transitory effects of higher housing inflation should not influence the monetary policy stance but RBI might like to stay on hold till there is more clarity on the timing/duration of the spike and its spillover on to more generalized inflation.
Once the 25 bps rate reduction is done in early 2016, CPI has to undershoot RBI’s 5% CPI target significantly for any space of further easing to open up. Given the stickiness of services inflation and erratic food inflation patterns, this is still not our base case but we will also be closely watching any intensification of downside risks to growth from a protracted global slowdown.
RBI seems to be emphasizing that the difference between the weighted average call rate and repo rate is a better indicator of liquidity conditions. Going forward, liquidity conditions could become tighter on account of a seasonal increase in currency in circulation and advance tax outflow in mid-March. As a response to tight liquidity, we believe the RBI would use a judicious mix of liquidity adjustment facility and open market operations rather than any reduction in cash reserve ratio. The RBI has indicated that it is developing a new framework for liquidity management. Markets will be eagerly awaiting the details on that.
The thrust of the policy seems to be maintaining macro stability. In this context, the challenge will be to fast-track deleveraging and resolving the bad loans problem of banks in an environment of relatively high real interest rates and a steepening yield curve.
Samiran Chakraborty is chief economist, India, at Citi Research, Citigroup Global Markets India Pvt. Ltd.
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