RBI monetary policy review: Raghuram Rajan statement signals continuity

The underlying theme of the policy statement was continuity, with no change in the growth or inflation targets, policy rate, accommodative stance of monetary policy and strategy to reduce the structural liquidity deficit. In particular, the announcement of an open market purchase of R10,000 crore of government bonds has cemented RBI’s intention to pare the structural liquidity deficit even though seasonal factors have led to a temporary surplus.

The central bank continues to expect growth of gross value added (GVA) at basic prices to rise from 7.2% in FY2016 to 7.6% in FY2017, around which risks are perceived to be evenly balanced. In ICRA’s view, the input cost-led push to GVA growth in FY2016 would recede in the ongoing year, with prices of several commodities having bottomed out. But volume growth would rise after the implementation of the Seventh Central Pay Commission’s recommendations and the expected pick up in kharif output boost consumption demand. This, in conjunction with the impending transition to the long-awaited goods & services tax (GST), is likely to encourage the private sector to expand capacities, which would be crucial to ensure that the uptick in economic growth is durable.

RBI also retained its inflation target of 5.0% for March 2017, continuing to view risks as skewed to the upside. Firm food prices in July 2016 are expected to result in the CPI inflation print for that month hardening further, from the 5.8% recorded in May-June 2016. Subsequently, a favourable base effect, in conjunction with the post-monsoon dip in food prices, would help to appreciably dampen inflation post-August 2016, offsetting the impact of higher global food prices. The extent of revival in demand after the pay revision, particularly for food products and services, poses an upside risk. However, the demand for manufactured products is less of a concern, given the as yet moderate capacity utilisation. The deferral in the revision of allowances based on Pay Commission’s recommendations is likely to temporarily benefit the CPI trajectory, as the rise in house rent allowance would eventually push up housing sub-index.

Monetary policy setting in India is set to enter a new era, with a new Governor as well as the shift towards a Monetary Policy Committee (MPC)-determined policy rate. Amidst these substantive changes, the government of India’s decision to retain the CPI inflation target at 4+/-2% up to March 2021 would impart stability to policy setting. This offers a window of almost five years to develop a new high-frequency indicator of growth in both industry and services, which may provide a credible and valuable substitute for comprehensive data on unemployment in India. Eventually, this may allow RBI to adopt a dual objective in place of the current framework of flexible inflation-targeting.

Nevertheless, within the aegis of the unaltered inflation targeting framework, ICRA continues to expect lower average CPI inflation in H2FY2017 to create space for additional monetary easing of 25bps in the remainder of 2016, irrespective of the composition of new MPC. Government security and commercial paper yields are likely to fall further in anticipation of this rate cut.

Some uncertainty lingers regarding final structure of GST rates and their impact on inflation. So, it is difficult to gauge the extent to which the MPC may choose to cut the repo rate in 2017, given the likely transition towards the mid-point of the inflation target band from the interim target of 5.0% in March 2017.

As compared to the cumulative 150bps that the repo rate has been cut by RBI since January 2016, the median reduction in banks’ one-year deposit rate has been similar (about 150 bps). However, the reduction in the banks’ lending rate (base rate) has been far more subdued, at about 60 bps. Some of the stated factors thwarting transmission have been removed, namely rigidity in small savings rates and liquidity deficit, complemented by RBI’s nudge to move to the Marginal Cost of funds based Lending Rate (MCLR) framework from April 1, 2016. Nevertheless, transmission of policy actions to bank lending rates is expected to improve only gradually.

The faster transmission of policy action in the debt capital markets coupled with the benefits accrued to banks on repricing of interest rates on deposits over the last few quarters as well as competition to on-board good quality assets is likely to help in reduction of the MCLR rates over the next few months, as RBI continues to reassure the market of adequate liquidity to meet the impending FCNR(B) redemptions.

As the banking system is facing challenges on many fronts, speedier development of the bond market could provide an appropriate platform for faster transmission of policy rates to the eventual borrowers, and also diversify the risk across market participants other than banks. In this regard, we await details on the proposed regulations to deepen the bond market.

(The author is managing director & group CEO, ICRA Ltd)