Home >Politics >Policy >RBI moves to boost cash supply

Mumbai: The Reserve Bank of India (RBI) opened the cash floodgates in its monetary policy review on Tuesday, facilitating growth in both the investment and the consumption sides of the economy.

The stock market, however, failed to see beyond the 0.25 percentage point rate cut in the announcement, which it considered inadequate. The BSE’s benchmark index tumbled 2.03%.

The rate cut, welcomed by the government, took the policy rate to its lowest in five years, but the other measures announced could facilitate transmission of previous cuts. Some analysts say the net effect could be as much as a 0.75 percentage point reduction in the lending rate.

RBI has cut rates by 1.5 percentage points (including this one) since January 2015, only about half of which has been passed on by banks through lending rate cuts.

That is good news for both corporate and individual borrowers. Better still, RBI hinted at another rate cut later in the year if inflation remains low.

The rate cut itself was expected—some analysts thought it would be more substantial—after inflation slowed to 5.18% in February and the government agreed to be conservative with its borrowing and stick to its fiscal deficit target of 3.5% of gross domestic product in its budget for 2016-17.

But RBI and its governor Raghuram Rajan had another challenge—getting banks to lower interest rates, something they had not done despite cuts in the policy rate, citing tight cash supply.

“Perhaps more important at this juncture is to ensure that current and past policy rate cuts transmit to lending rates," RBI said.

This month, RBI had already invoked new rules forcing commercial banks to set lending rates based on prevailing market rates.

To give banks more comfort, RBI reduced the cash proportion of banks’ reserve requirements that must be kept with the central bank (from 95% to 90%) while also pledging to inject more long-term liquidity.

And as part of a balancing act to reduce the risk of cash flooding the system, RBI also unexpectedly raised the reverse repo rate—or the rates lenders charge to the central bank—by 25 basis points to 6%. A basis point is one-hundredth of a percentage point.

RBI said it would inject more “durable" liquidity over the next 12 months by buying bonds via open market operations or by buying dollars and selling rupees every month.

RBI added that it would maintain “neutral" liquidity as compared with a deficit of 1% of deposits that it was trying to maintain until now. This will happen over the course of the year, the central bank indicated.

“Today’s decision was more focused on addressing liquidity shortage and easing the transmission mechanism," said Radhika Rao, an economist at DBS Bank in Singapore.

“This is to ensure that the easy policy stance percolates to the real economy and materially lowers financing costs."

The central bank backed its actions with words and announced an open market operation to buy bonds through which it will infuse 15,000 crore into the system this week. The cash deficit in the system has been close to 2 trillion in recent weeks but part of this is due to year-end factors such as advance tax payments. An increase in the cash in circulation, possibly due to state elections, has also pushed up the deficit.

While most market participants had expected some liquidity-enhancing measures, a complete shift in the central bank’s liquidity stance comes as a positive surprise and will help bring down rates in the system over time.

“I am very happy. We should not worry about the short-term reaction in the market. The RBI intends to bring liquidity into neutrality and I think it would happen sooner than the market expects," said Ananth Narayan G., managing director and regional head for financial markets, Asean and South Asia, at Standard Chartered Bank.

Narayan expects bond yields to fall by 25 bps over the next few month once RBI begins injecting long-term liquidity. Short-term yields are also likely to fall sharply by at least 30 bps, he said.

The shift in the liquidity stance will help banks lower their lending rates and thus transmit the policy rate cuts to industry, said Rajan. The central bank noted that the new regime of marginal cost-based lending rates (MCLR),along with the lower rates on small savings announced by the government last month, will help in improved transmission of its rate cuts, including those announced last year.

Rajan said the MCLR has itself brought down rates by 25-50 bps.

“Don’t look at it as a 25 bps (cut), look at it as a composite measure," he said, while explaining the policy decision.

Minister of state for finance Jayant Sinha welcomed RBI’s rate cut and liquidity-enhancing efforts and said they would stimulate the economy.

Bankers say that rates will ease, but over time.

Jairam Sridharan, chief financial officer, Axis Bank Ltd, said a lot will depend on how individual banks price their loans.

“The deposit rates will be repriced first and this will show an immediate change in the MCLRs of banks, making lending cheaper. Each bank will decide the timing of these rate reductions on its own. In case of Axis you will see this sooner than later," Sridharan said.

RBI said inflation is expected to be around 5% for the most part of fiscal 2017 and retained its target of 5% consumer price inflation by March 2017.

RBI intends to bring down headline inflation to 4.2% by fiscal 2018, according to the monetary policy report that accompanied the policy statement.

However, both the projections do not factor in an upside to inflation from wage hikes under the Seventh Pay Commission recommendations.

Retail inflation has been easing and touched a four-month low of 5.18% in February. Most analysts expect inflation to ease further in fiscal 2017 contingent upon a normal monsoon. The recent rebound in global commodity prices may pose some upside risks to domestic inflation.

“Inflation has evolved along the projected trajectory and the target set for January 2016 was met with a marginal undershoot. Going forward, CPI inflation is expected to decelerate modestly and remain around 5% during 2016-17," RBI said in its statement.

The accompanying monetary policy report stated that a normal monsoon and further fiscal consolidation in line with the path set out by the government could bring inflation down to 4.2% by the fourth quarter of fiscal 2017-18.

“The stance of monetary policy will remain accommodative. The Reserve Bank will continue to watch macroeconomic and financial developments in the months ahead with a view to responding with further policy action as space opens up," said RBI. However, there are risks, the central bank warned, referring specifically to a new pension scheme for retired servicemen and a salary hike for government employees.

The outlook on growth remains mired in uncertainties even though the central bank retained its growth forecast for the year at 7.6%.

The monetary policy report highlighted a number of factors that could weigh on growth this year. These include debt-heavy balance sheets of the corporate sector and low capacity utilization. Some of these pressures may get balanced out by stronger consumption demand, the central bank added.

“A number of factors could impinge upon the growth outlook for 2016-17. First, slow investment recovery amidst balance sheet adjustments of corporates is likely to hinder investment demand. Secondly, with capacity utilisation in the organised industrial sector estimated at 72.5%, revival of private investment is expected to be hesitant. Thirdly, global output and trade growth remain tepid, dragging down net exports," said the central bank in its monetary policy report.

The government’s “start-up" initiative, strong commitment to fiscal targets, and the thrust on boosting infrastructure could brighten the investment climate, RBI added, while suggesting that consumption demand could benefit from the increase in the salaries of government employees, past interest rate cuts and measures to boost the rural economy.

Benchmark equity indices posted their biggest decline in nearly two months, in line with weak world equities.

The BSE’s 30-share Sensex fell 516.06 points, or 2.03%, to 24,883.59 points, while the NSE’s 50-share Nifty shed 155.60 points, or 2.01%, to 7,603.20 points. It was the biggest decline since 11 February for both.

“Globally, the markets weren’t doing good and most of them were in the red," said Hemang Jani, senior vice-president, advisory, at brokerage Sharekhan Ltd. “On the domestic front, there were rising expectations of a 50 bps cut by RBI, and that didn’t happen. Market was looking for a reason to correct, after the recent rally, and these factors triggered it."

Ami Shah contributed to this story.

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