Monetary policy: Why the MPC chose to maintain status quo…

The 5th Monetary Policy for the financial year 2016-17 was announced by the RBI on December 07th after 2 days of deliberations by the Monetary Policy Committee (MPC). It is necessary to understand the background to the policy to appreciate the key announcements in a better perspective. Firstly, there is the demonetization exercise whose full impact is yet to be seen. Secondly, there is the all important Fed policy that is coming up on December 15th where there is almost a consensus on a rate hike. CPI Inflation and Food inflation have been trending lower but the OPEC decision to curtail supply has pushed up oil prices. That may have larger implications for future inflation trajectory in India. Lastly, growth has been lagging and demonetization has only made it worse in the recent quarter ended September 2016. However, it is not certain if a rate cut will actually push up growth at a time when there is a tremendous imbalance between currency impounded and fresh currency issued.

Highlights of the Monetary Policy announcement…

The Policy Repo rate has been kept constant at 6.25%

This keeps the reverse repo rate at 5.75% (Repo-50 bps) and the Bank rate at 6.75% (Repo+50 bps)

The CRR has been maintained at 4% of net demand and time liabilities (NDTL) and the SLR has been maintained at 20.75%.

Incremental CRR of 100% on deposits post Sept 16th 2016 stands withdrawn effective December 10th 2016

Why were the rates not cut by the MPC?

Contrary to analyst expectations, the MPC maintained status quo on rates. In fact, the markets were expecting a 25 bps cut on the conservative side and a rate cut of 50 bps on the optimistic side. The decision to maintain status quo on rates was essentially predicated on 4 key factors…

Firstly, the inflation had some key upside risks from current levels. The CPI inflation for October had come in at 4.20% with food inflation at 3.39%. However, the real risk for inflation came from non-food inflation which has remained sticky in the last couple of months. The MPC has also been concerned about the rise in oil prices. Brent Crude has moved up from $46 to $54 since the supply cut was announced by the OPEC on November 30th at Vienna. This is likely to translate into higher imported inflation for India. This has prompted the RBI to be cautious.

The weak growth in GDP and GVA has been a good basket case for cutting rates. In fact, the RBI in its policy statement has downgraded the Gross Value Added (GVA) for 2016-17 to 7.1%. For the full year, the overall growth may get closer to the 6.8-7.0% range as predicted by Fitch and some leading global broking houses. A large part of this fall in growth will be caused by the after effects of the demonetization exercise. The MPC believes that even if rates are cut at this point of time, the salutary impact may be limited as the banking sector is already constrained by the imbalance between currency impounded and currency issued. Hence rates cuts may not really work to prop up GDP growth.

Thirdly, the MPC has expressed the view that the outcome of the demonetization exercise may have to be observed more closely. Indian industry is already operating at around 70% capacity utilization. The squeeze created by the demonetization exercise will only accentuate the problem of insufficiency of demand. As a result a rate cut at this point of time may not really translate into a tangible growth in credit or in output. This has also dissuaded the RBI from cutting rates at this point of time.

Lastly, there is the all important Fed meet that is coming up on December 15th. The yield spread between the US 10-year G-Sec and the India 10-year benchmark has already compressed by over 200 bps over the last few months. With the US likely to hike rates and give a hawkish outlook, any rate cut at this point of time would have only narrowed this gap further. This will not be good news for FPI flows since India has already seen FPI outflows to the tune of $5 billion in the month of November. Sharper portfolio outflows could spoil the pitch for capital flows as well as the external value of the INR at a time when most bank treasuries are already veering towards an INR level of 70/$.

Focus shifts to Feb Monetary policy…

The actual logic of the decision to maintain status quo on rates will be known when the detailed deliberations of the MPC are made public on 21st December. The MPC seems to have decided to adopt a more conservative approach. By putting off the rate cut to February 2017, the MPC has given industry and banks sufficient time to adjust to the demonetization as well as the INR to adjust to the cues coming from the Fed and flows. The focus will now shift to Feb 08th 2017, when the sixth and last credit policy for the current fiscal year will be announced!