1. Enhancing the transmission process

Enhancing the transmission process

Restricting repo rate cut to 25bps an appropriate step; focus on liquidity to improve transmission

By: | Published: April 7, 2016 12:36 AM

As anticipated, the Reserve Bank of India (RBI) chose to restrict the repo rate cut to 25 basis points in its April 2016 policy, rather than front-loading a larger rate cut. In our view, the central bank’s focus on easing systemic liquidity should further enhance the transmission process, augmenting the impact of the reduction in small savings rates and the implementation of the new Marginal Cost of Funds based Lending Rate (MCLR) regime by banks.

Easing concerns regarding the central government’s fiscal stance and the decline in CPI inflation in February 2016 supported the case for the rate cut. The quantum of the reduction in the repo rate is appropriate in our view, in light of the continuing uncertainty to the inflation trajectory, unfolding improvements in the transmission process and the anticipation of healthy economic growth.

Factors such as the impact of the staggered pay revision by the central and various state governments as well as the impact of the monsoon dynamics in 2016 on food prices continue to pose concerns for the inflation trajectory, even though the outlook for commodity prices remains muted in light of sluggish global growth.

Assuming that the Seventh Central Pay Commission’s recommendations are implemented by Q2-FY2017, RBI has assessed that CPI inflation would rise on an average by 100-150bps above its baseline projections for 2016-17 and 2017-18, through the direct (higher house rent allowance) and indirect (a pick up in consumption and hardening of inflationary expectations) channels. This has cast a sobering pall on the outlook for CPI inflation, which is intended to be brought down to 5% by March 2017 and 4% by March 2018.

The speed of transmission of monetary easing to bank deposit as well as lending rates is set to improve over the course of the ongoing quarter, with the reduction in small savings rates by the Indian government and the implementation of the MCLR regime by banks with effect from April 1, 2016. As compared to the 125bps of reduction in the repo rate since January 2015, interest rates on various small savings schemes (except savings deposits), which pose competition to bank deposit mobilisation, have been pared by 40-130bps for the first quarter of 2016-17 relative to the rates prevailing in 2015-16. Importantly, going forward, interest rates for small savings schemes are to be recalibrated each quarter, which would reduce the impediments to monetary transmission.

Under the new MCLR regime, the extent of transmission to lending rates would be linked to the magnitude of reduction in term deposit rates as well as the proportion of term deposits in the overall funding profile of banks. If banks reduce their deposit rates by a magnitude equivalent to the expected repo rate cut of 25bps and term deposits constitute 60% of their funding, we estimate the MCLR to decline by 60% of the repo rate cut, i.e. 15bps.

Amidst weak global growth prospects, RBI maintained its GVA (gross value added) growth projection for the Indian economy for the ongoing fiscal at 7.6%, describing risks as evenly balanced. ICRA continues to expect growth of GVA at basic prices to improve to 7.7% in 2016-17, similar to the central bank’s baseline projection.

Systemic liquidity tightened significantly in H2-FY2016, particularly in the last quarter. The net infusion of liquidity averaged Rs 1.6 lakh crore in Q4-FY2016, one of the chief reasons for which was high government cash balances, which averaged Rs 1.1 lakh crore in the same period. Hardening interest rates in the commercial paper market resulted in a shift to bank credit.

Additionally, a surprisingly sharp rise in currency with the public dampened deposit accretion. As a result, the incremental credit-deposit ratio, which rose from 66% in FY2015 to 86% in FY 2016, increased from 48% in H1-FY2016 to 200% in H2-FY2016, aggravating the tightness in systemic liquidity.

The focus of the April 2016 monetary policy statement on smoothing systemic liquidity is a positive development, which should support the transmission process. The change in stance on maintaining systemic liquidity closer to a neutral position rather than a deficit and the halving of the policy rate corridor would also aid in softening interest rates, at least in the short term. For instance, RBI has already announced an open market operation to purchase R15,000 crore of bonds, which would infuse durable liquidity into the system.

Over the next few quarters, we look forward to new regulations from the central bank on differentiated banking licences, steps to continue strengthening the domestic financial system, introduction of new products and regulations to deepen the financial markets, and broaden market participation.

The continued description of the monetary policy stance as accommodative lends a modestly dovish tilt to the policy statement, suggesting that RBI would reassess the space for further easing once risks to the inflation outlook recede. Nevertheless, it is premature to gauge whether further space for monetary easing will materialise as the fiscal year progresses.

The author is MD & CEO, ICRA Ltd

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