Photo: Aniruddha Chowdhury/Mint
Photo: Aniruddha Chowdhury/Mint

A surprising pause and an expected CRR reversal

The tone of the monetary policy statement served to underscore the independence and credibility of both RBI and its monetary policy committee

In another unanimous decision, the monetary policy committee (MPC) of the Reserve Bank of India (RBI) left the repo rate unchanged at 6.25% in its second meeting, following the 25 basis points (bps) rate cut in its debut. This pause surprised the markets, which had pencilled in a rate reduction in the December policy review, the first meeting of the MPC after the withdrawal of legal tender status for the old notes of Rs500 and Rs1,000.

However, this was the only major surprise in the December policy statement. As expected, the accommodative stance on monetary policy and the neutral stance on liquidity were retained, and the recent cash reserve ratio (CRR) hike was rolled back. Moreover, the gross value-added (GVA) growth forecast for FY2017 was cut by 50bps to 7.1% from 7.6%, with evenly balanced risks. The MPC assessed the impact of currency replacement on the economy to be transitory but evolving at present, with a moderation in growth in Q3 FY2017 likely to be followed by a subsequent strong rebound.

Additionally, the upside risks to the Q4 FY2017 consumer price index (CPI) inflation forecast of 5% were viewed to be more moderate than feared previously, despite emerging concerns related to firming domestic prices of certain food items and global crude oil prices.

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The MPC’s first policy statement and minutes had implied a clear skew towards growth concerns. Given that it maintained an accommodative stance for monetary policy, its decision not to cut rates suggests that its focus has undoubtedly shifted back to inflation concerns, and the medium-term target of 4%, plus or minus 2 %. In our view, the CPI inflation would undoubtedly trend upward during Q4 FY2017 as the favourable base effect wanes, but will remain below the RBI’s projection of 5%. The MPC had previously indicated that real interest rates may need to be below 150bps in the global scenario of negative rates, compared with the earlier range of 150-200bps. With no further downward revision in this stance, the room for further rate cuts appears to be limited to 25bps over the next six months, unless the expected rebound in GVA growth does not materialize.

Reacting to the unexpected pause in the repo rate relaxation, the 10-year government security (G-sec) yields spiked by a substantial 20bps, which suggests that the market too has pared its projection of further rate cuts to 25bps from 50bps. This pause may help to stem foreign institutional investment (FII) outflows from the debt markets.

However, the subdued outlook for consumption and corporate earnings, in addition to the global flight to safer assets, suggest that FII equity outflows may continue for some time. The deferral of a rate cut would also help to strengthen the rupee, which has weakened in the recent weeks in line with the secular strength of the US dollar.

As expected, the temporary requirement to maintain 100% CRR on the incremental net demand and time liabilities (NDTL) raised between 16 September and 11 November was reversed by the RBI with effect from the next reporting fortnight. This increase in the CRR had meant that the banks would not earn anything on those deposits, while continuing to pay interest on them. The withdrawal of the CRR hike would now provide some room to banks to cut lending rates, following the surge in deposits to the tune of Rs11.55 trillion over the past month, as indicated by the RBI.

However, the central bank has retained its neutral liquidity stance. Therefore, a phased issuance of securities within the market stabilization scheme’s (MSS) revised ceiling of Rs6 trillion would continue, absorbing the excess inter-bank liquidity, while compensating the banks with some interest on such funds. Since 2 December, Rs1.6 trillion of short-term securities have already been issued, at yields in excess of 6%.

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In ICRA’s view, if the government and RBI intend to transition the economy to a lower currency-to-GDP ratio with increasing non-cash transactions, then banks’ deposits may remain elevated compared to the situation on 8 November. This represents a structural shift in systemic liquidity, warranting open market sale of G-secs to permanently absorb liquidity, rather than using those bonds as collateral for overnight or term reverse repos.

During the press conference, RBI officials strongly indicated that the withdrawal of legal tender character for the old currency notes does not extinguish the liability on the central bank’s balance sheet. They clarified that notes not returned by the public will remain a liability of the RBI, laying to rest the expectation regarding the transfer of windfall gains to the central government.

Overall, the tone of the policy statement served to underscore the independence and credibility of both the central bank as well as its monetary policy committee.

Aditi Nayar is principal economist at ICRA Ltd.

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