Monetary Policy Announcement By RBI & Key Takeways

The Sixth Monetary Policy for the fiscal year 2016-17 was announced by the RBI on 08th February 2017. It is essential to understand the backdrop to this policy announcement. Firstly, there is the demonetization exercise that was undertaken in the months of November and December 2016. Secondly, the RBI had already front-ended a rate cut in its October policy and had maintained status quo in December due to expectations of a Fed rate hike. Lastly, the global situation is currently in a state of flux with the US looking to make large-scale changes in its trade policies and UK preparing for a full-fledged BREXIT.

Highlights of the Monetary Policy Announcement, Feb 08th…

• The repo rate under the liquidity adjustment facility (LAF), which is the macro indicative rate, has been kept constant at 6.25%.
• As a result the reverse repo rate remains at 6.75% and the bank rate as well as the marginal standing facility (MSF) remains static at 6.75%.
• The cash reserve ratio (CRR) is left unchanged at 4% and the SLR level also remains unchanged at 20.75%.
• The RBI continues to make efforts to keep the financial markets in a liquidity neutral situation by using reverse repos to absorb liquidity created by the demonetization drive

Why status quo on rates – The stickiness of inflation…

One of the primary drivers for a status quo on rates was the rate of inflation. The RBI has set a target of 5% CPI inflation for the fourth quarter and 4% target for subsequent quarters. The CPI inflation has stayed under the 4% mark in recent months but the RBI believes that this was largely driven by the base effect. The sharp fall in food inflation was largely driven by deflation in pulses and vegetables which was not a sustainable scenario in the longer run. On a slightly more worrying note, the RBI finds the non-food inflation consistently sticky at around the 4.9% mark. Also India being a net importer of oil to the extent of 80% of its annual needs, any rise in oil prices could change the inflation calculations in a big way. Consequently, the RBI has decided to play on the side of caution and observe inflation for a couple of months before taking the call. The RBI surely sees distinct upside risks to non-food inflation and that was one of the key drives for status quo on rates.

Why Status Quo on rates – Watch the growth correlation for a little longer…

The good news is that the RBI has not downgraded GDP growth substantially. While the street was expecting the RBI policy analysis to downgrade the GDP growth to 6.2%, the RBI has projected the full year growth for 2016-17 at a more acceptable 6.9%. This is almost at par with the advance estimate of 7% put out by the Central Statistical Organization (CSO) in early January 2017. Considering the combined effect of demonetization and a global tepidness in growth, 6.9% would be a good growth rate to achieve for the full financial year. The RBI recognizes that even with another rate cut, the growth for this year cannot be substantially pushed up from these levels. Hence a rate cut at this juncture may not add much value at this time from a macroeconomic standpoint.

Why Status Quo on rates – Hold on; demonetization has done the transmission job…

Till one quarter ago, the big complaint that the RBI had about banks was that the full impact of rate cuts were not being passed on to the end customer. However, things changed after the demonetization drive was announced. Banks receive a huge influx of funds and this resulted in banks facing a mismatch. They just could not afford to pay interest on deposits and not earn interest on loans. SBI took the lead by cutting the MCLR by 90 basis points and most other banks followed suit. This mean that the banks have now transmitted more than what the RBI has cut since January 2015 to the end customer. The objective of lowering the cost to the end customer has anyways been achieved by the RBI through better transmissions rather than through rate cuts. That gives the RBI the leeway to hold rates and evaluate its impact on credit growth before taking a final call on rates.

Why status quo on rates: Global markets are still in a state of flux…

There are just too many unanswered questions in the global economic scenario. What happens to global trade if the US gets increasingly protectionist? How large could be the collateral impact of BREXIT on UK and the EU is still now known? There is a big question mark over US-China trade relations. If the US starts putting trade restrictions on China, it could have larger repercussions. Either China will be forced to retaliate or China will let the Yuan depreciate. The second choice will be more productive for China from a long term standpoint. However, it will result in other EM currencies also depreciating leading to a mini-currency war among the EMs. But the big worry could be on the Fed rate outlook. Even as the Fed maintained rates in February, Yellen has given a very hawkish view hinting at a minimum of 2 rate hikes in 2017. The RBI needs to be prepared for this eventuality as it would narrow the yield spreads between India and the US and result in a surge in capital outflows. India will surely want to avoid repeating the experience of mid-2013.

In a nutshell, the RBI may reconsider its rate stance in its next policy on April 06th. By then, the US policy stance will be much clearer. Also the front-ending of rate cut in October reduces the leeway with the RBI. For the time being we will have to wait till February 22nd when the MPC minutes will be published to understand the complete nature of deliberations behind this decision.