Further monetary easing may be limited to 25bps in 2016

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Published: February 3, 2016 1:13:12 AM

As anticipated, the Reserve Bank of India (RBI) desisted from changing its key policy rate in the final bimonthly monetary policy review for 2015-16.

As anticipated, the Reserve Bank of India (RBI) desisted from changing its key policy rate in the final bimonthly monetary policy review for 2015-16. For one, the central bank is awaiting clarity regarding the fiscal stance and structural reforms that the Union government would adopt in the forthcoming Budget for 2016-17. Moreover, its expectation of a mild pick-up in growth of gross value added (GVA) at basic prices to 7.6% in 2016-17—from its projection for 2015-16 of 7.4% with a downward bias—supported the status quo. Additionally, RBI continues to anticipate that CPI inflation would evolve in a manner consistent with the previously announced target of 5.0% in March 2017.

In the Union Budget for 2015-16, the government had committed to paring its fiscal deficit from 3.9% of GDP in 2015-16 to 3.5% of GDP in 2016-17. This task has been made more challenging by the looming pay revision based on the Seventh Central Pay Commission’s recommendations, the impact of which is estimated at 0.65% of GDP. Therefore, the extent of fiscal compression to be undertaken in the coming year is substantial. To an extent, lower global fuel prices would both boost indirect tax revenues and dampen the outgo on fuel and fertiliser subsidies. The mix of other revenue augmentation and expenditure correction measures undertaken by the government to avoid a fiscal slippage would be crucial. In light of the inevitability that curtailed spending may dampen growth impulses, the central bank highlighted that it would watch for growth-supportive structural reforms in the upcoming Budget.

Moreover, as has been highlighted by RBI in the past, structural reform of small savings interest rates that would make them more market-linked is still awaited. This would aid in improving the transmission process, and complement the measures taken by RBI such as the impending introduction of the marginal cost of funds based lending rate mechanism.

Liquidity conditions have tightened over the last two months on the back of advance tax outflows, and a pick-up in bank credit especially in sectors like retail and SME, while deposit mobilisations remain subdued. Subdued government spending, as evinced by the sharp increase in the surplus maintained with RBI in January 2016, has also contributed to tightening systemic liquidity. However, RBI has infused adequate liquidity through term repo and open market operations and ensured that the money market rates remained close to the benchmark policy rates. We expect RBI to continue to provide adequate liquidity to meet the requirements of productive sectors while managing inflationary expectations.

Various high frequency indicators suggest a moderation in GVA growth in Q3FY16 as compared to 7.4% in Q2FY16, including the slowdown in growth of the core sector output, railway freight, diesel consumption, etc. Moreover, the contraction in non-oil merchandise exports (in dollar terms) deepened in Q3FY16 as compared to Q2FY16. In contrast, the year-on-year growth of automobile production firmed up to an extent in Q3FY16 on a sequential basis. In ICRA’s view, growth of GVA at basic prices would be restricted to 7.2% in 2015-16, before rising to 7.7% in 2016-17, benefiting from a pick-up in consumption demand post the pay revision. Moreover, a cyclical upturn in agriculture following from the expectation of a normal monsoon in 2016 would restore the purchasing power of the farm sector and generate an uptick in rural demand. Nevertheless, a broad-based pick-up in investment remains distant despite the reforms undertaken so far by the government.

Although CPI inflation firmed up to 5.6% in December 2015, it is likely to cool in January 2016 with the decline in retail prices of various food items, petrol and diesel. As a result, the CPI inflation print for January 2016 (to be released in mid-February 2016) is expected to undershoot the target of 6.0%. In addition to the fiscal and inflationary impact of the pay revision, uncertainty related to the monsoon, the increase in minimum support prices and efficacy of food management, as well as the extent of depreciation in the rupee are other factors posing risks to the achievement of the target to reduce CPI inflation to 5.0% in March 2017. On the other hand, softness in global commodity and crude oil prices and, consequently, domestic fuel prices would keep CPI inflation moderate.

While RBI continued to describe its own stance as accommodative, it characterised the expected inflation trajectory as inertial, without factoring in the impact of the Pay Commission award. Presuming a normal monsoon in 2016 and fiscal consolidation along the previously announced trajectory, we expect further monetary easing to be limited to 25bps in 2016.

The author is MD & Group CEO, ICRA Ltd

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