The Reserve Bank of India (RBI) kept the benchmark rates unchanged in its recent monetary policy review, which was anticipated given that it had front-loaded a higher-than-expected rate cut in September 2015. The central bank has maintained a neutral stance in the latest policy statement, as it emphasised that it would ascertain the space for further accommodation with respect to the projected disinflation path that intends to take inflation down to 5% by March 2017, while focusing on the inflationary impact of commodity price movements, external developments, inflationary expectations, and the Pay Commission award. At the same time, the central bank indicated mild downside biases to its 2015-16 projections for GVA growth for 2015-16 (7.4%) and the CPI inflation trajectory.
Although RBI maintained its vigilance on the inflationary risks, it seemed more focused on the need to improve the efficiency of transmission of its policy actions to support growth. As we await the issuance of the final guidelines by the central bank, we believe that banks would face shrinkage in their net interest margins till the time their deposits get re-priced to lower levels (on a par with the marginal cost of funds), especially in a declining interest rate scenario, given the structural profile of assets and liabilities of the banking system. The possibility of the government linking the small savings interest rates with market rates would provide opportunity to banks to further reduce deposit rates and, consequently, the lending rates, thereby improving speed and extent of monetary policy transmission.
Accordingly, while the borrower segment may benefit from the likely reduction in lending rates, the investor segment could be further impacted on lower rates on deposits.
Notwithstanding the relative tight liquidity conditions during the festival season, the money market rates remained around the policy repo rates in October-November 2015, indicating adequate systemic liquidity. With the next instalment of advance tax payments approaching, RBI has now announced a 28-day term repo of R250 billion, to ease the frictional pressures, as well as open market purchases of R100 billion of government securities, to address structural liquidity mismatches. Further, the excess SLR maintained by the banking system and the expectations of the central bank to use tools available with it to smoothen systemic liquidity will provide scope for credit growth in the ensuing busy season.
With RBI intending to closely monitor misuse of the concessions such as 5/25 and strategic debt restructuring schemes, the expectations that banks clean up their balance sheets by March 2017 and also recognise stressed loans sooner rather than later could be difficult for many banks given the challenges they face currently. We believe that the public sector banks will require significantly higher equity capital from the government to meet the higher provisioning requirement for stressed assets as benefits from expected strong tailwinds on the economic front and improvements in the cash flows profiles of stressed corporate group could take longer than expected.
In terms of global factors, the imminent rate hike by the US Federal Reserve and persisting concerns regarding a slowdown in China would keep global commodity prices benign. However, the impact of the same on domestic inflation indices may be somewhat offset by a weakening of the INR relative to the USD.
On the agricultural front, unfavourable soil moisture conditions and reservoir storage levels in large parts of the country have contributed to delays in sowing of several rabi crops. This, in conjunction with the recent hike in minimum support prices for various winter crops, would exert pressure on food prices in the near term. Moreover, supply constraints related to services would keep services inflation sticky, and prevent a meaningful moderation of households’ inflationary expectations.
In my view, the fiscal impact of the pay award on the government of India’s (GoI’s) target of restricting its fiscal deficit to 3.5% of GDP in FY17, while challenging, is not insurmountable. However, the magnitude and timing of pay revision at the state level and the extent of fiscal discipline displayed by the state governments remains unclear. In aggregate, the 29 Indian states have substantial investments in Treasury-bills, of R1,245.1 billion as on November 20, 2015. While the cap set by the Union government on states’ annual net borrowings, of 3.0% of GSDP, is intended to curtail the fiscal deficits of the latter at an equivalent level, availability of liquidity through T-bill holdings allows the state governments to circumvent this constraint. In ICRA’s view, some states are likely to draw down their T-bill holdings in order to fund the fiscal impact of the pay revision that they undertake going forward, rather than necessarily maintaining their fiscal deficit below 3.0% of GSDP. Given the uncertainty on the fiscal and inflationary impact of the upcoming pay revision for state and central government employees, We expect RBI to maintain benchmark rates at current levels until the presentation of the Union Budget for 2016-17.
The author is MD & Group CEO, ICRA Ltd