In line with our expectations, the Monetary Policy Committee (MPC) of Reserve Bank of India (RBI) decided to leave the repo rate unchanged and retained the neutral stance of monetary policy in the second policy review for FY18. Notably, this is the first instance that the MPC’s decision was not unanimous. The repo rate was maintained at 6.25% in the June 2017 policy even though the CPI inflation has printed below 4% (the medium term target) for six consecutive months and economic growth in Q4 FY2017 surprised on the downside, with the committee cautioning that premature action could risk subsequent disruptive reversals, entailing some loss of credibility. In terms of the outlook for FY18, the MPC forecasts a strong rebound of 70 bps in growth of gross value added (GVA) at basic prices to 7.3%, from 6.6% in FY2017. Additionally, the MPC continues to expect the CPI inflation trajectory to slope upward during FY18, from a low 2.0-3.5% in H1 to 3.5-4.5% in H2, and expressed some doubts whether the unusually low reading in April 2017 would endure. The MPC highlighted that underlying inflation pressures related to input costs, wages and imported inflation warrant close and continued monitoring. Additionally, farm loan waivers, and the fiscal slippages that they may engender, were flagged as an inflationary risk.
However, the MPC indicated that it does not expect the implementation of the GST to have a material impact on overall inflation, which has been highlighted as a risk in the previous policy review. Moreover, the revised inflation trajectory is appreciably lower than the assessment made in April 2017. In line with this, the tone of the June 2017 policy was far less hawkish than the April 2017 statement as well as the minutes of the MPC’s April 2017 meeting. In our view, the moderation in the CPI inflation forecasts suggest that the possibility of one rate cut of 25 bps in 2017, may have opened up. The latter has contributed to an intra-day fall in yields on government securities (G-sec) of around 8-10 bps.
The reduction in risk weights and standard asset provisioning for new individual home loans reiterates the regulatory impetus to a segment that has forward and backward linkages to the economy and also has largely stood resilient to asset quality pressures. Supporting the government’s objective of housing for all by 2022, this action may prod banks to further cut lending rates to this segment. Moreover, the reduction in the SLR rate will provide greater flexibility to meet the requirements under the liquidity coverage ratios. However, the introduction of the all in cost cap for the rupee denominated bonds at 300 bps over the similar tenure G-Sec may be a dampener, as the access to this route may now be available only to stronger entities.
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RBI reiterated its stance of bringing systemic liquidity closer to neutrality. With the year-on-year expansion in bank deposits (12.1%) continuing to sharply outpace credit offtake (6.4%) as on May 12, 2017, systemic liquidity remains in surplus mode. Bank credit growth has been muted because of demand side pressures such as the sluggish investment cycle of corporates and moderate working capital requirements; a surge in finer priced domestic debt market issuance; and weak capitalisation of the public sector banks, which account for a major share of advances.
The transmission in lending rates by the banks continues to lag the cut in policy rates, banks deposit rates as well as the yields offered in the debt market. Although banks continue to lose higher-rated clients to the debt capital markets, cuts in bank lending rates will pressurise their profitability levels in the absence of credit growth, if not supported by sharp fall in cost of funds.
Given the recent quarterly slippages reported by PSU banks, the government may ramp up the allocation for recapitalisation. However, this would be a key risk to achieving the central government’s fiscal consolidation plans. With the Insolvency & Bankruptcy Code requiring time-bound decisions, the ordinance issued recently by the GoI and the discussions being held by RBI with stakeholders would hasten the process of resolution for banks’ stressed assets. However, consensus needs to be reached on major issues such as the role of various stakeholders, the extent of haircuts to be taken by banks and fresh equity to be brought in by promoters.
Overall, the inflation outlook and the tone of the policy document suggest the possibility of a final rate cut during the later months of 2017. Nevertheless, in the scenario of continuing abundant liquidity, a modest cut in policy rates is unlikely to be adequate to spur a meaningful pickup in credit growth.