Monetary Policy review – December 2016


More often than not, monetary policy decisions of RBI have surprised all.

On the occasion of 5th bi-monthly monetary policy review, most of the economists, experts and brokerage houses experienced this. A few thought RBI would cut policy rates by 25 bps (basis points) and some optimists predicted a 50 bps rate cut.

But, RBI saw no merit in doing so and maintained repo rates unchanged. Reduction in inflation over last few months and a possible cool down in the Indian economy, in the aftermath of demonetisation were considered primary reasons for a probable rate cut.

The following are the key highlights of the RBI Monetary Policy:

  • The Monetary Policy Committee (MPC) of the Reserve Bank of India, in a surprise move, left the key interest rates unchanged. The repo rate remains at 6.25%.
  • It came as a 'surprise' since almost everyone was expecting the RBI to cut the repo rate by at least 25 bps. There were many who expected a steeper cut of 50 bps.
  • The MPC, a six-member committee which decides on the interest rates, was unanimous in its decision as it voted 6-0 in favor of keeping rates steady. Thus, it shows the difference in view of the RBI and the street expectations.
  • With this unexpected move of holding rates steady, we believe the RBI has made a big statement towards its independence and objectivity.
  • The RBI has very rightly chosen to ignore market expectations of large rate cuts and has opted to wait and watch the actual impact of demonetization on inflation and growth.
  • The non-consensus move of holding rates steady was thus a major shock. The stock and bond market reaction clearly showed it.
  • The 10-year government bond yield went up by 21 bps to end the day at 6.41%. Before the rate cut, the 10-year bond yield traded as low as 6.16%, suggesting that the bond markets were expecting a more than 25 bps rate cut by the RBI and were clearly disappointed with the outcome.
  • Importantly, the "no rate cut" today does not mean there are no chances of further rate cuts.
  • If the effects of demonetization lead to lower inflation and slower growth, the RBI will look to cut rates in its February policy review. By February, the RBI will also have greater clarity on the global situation (notably a potential FED rate hike and some clarity on Donald Trump's policies) as well as India's fiscal deficit for FY2017-18, which would allow them to take a more balanced view.
  • Despite no rate cut today, we would still expect banks to keep lowering their lending and deposit rates in the next few months.

How the event turned out to be?

RBI had something unexpected in store. It remained upbeat about the Indian economy and also turned down all possibilities of inflation sliding down unhealthily.

GDP growth estimates:

The RBI revised the GDP estimates downwards from 7.6% to 7.1%. It believes the strong performance of the agricultural sector and revival in the consumption on the back of implementation of One Rank One Pension (OROP) and 7th Central Pay Commission (CPC) would negate the impact of demonetisation. The downward revision in GDP is based mainly on the downward revision in the Q2FY17 numbers.

Inflation Outlook:

RBI expects the effects of demonetisation to be only transient. Surprisingly, the impact of demonetisation on the inflation would be only in the range of 10-15 bps. In contrast to the popular belief, RBI estimates firming up of food prices led by Sugar and confectionery products, cereals, protein rich food, pulses and processed foods among others. Surprisingly, it doesn't see any risk of core inflation sliding substantially.

In fact, it fears the recent trend of falling inflation may be only temporary as the favourable base effect enjoyed in October won't be available for months to come. Moreover, effects of OROP and 7th CPC haven't played out completely as yet. Having said that, the central bank remains confident about being able to achieve the retail inflation target of 5.0% by the end of Q4FY17.

Liquidity situation:

As mentioned by the RBI, banks have witnessed an inflow of close to Rs 11.55 lakh crore worth scrapped currency notes by December 6, 2016. Such gush of liquidity resulted in surplus liquidity position in the system. To deal with the problem of excesses, RBI had prescribed an incremental cash reserve ratio (CRR) of 100% of Net Demand and Time Liabilities (NDTL) on November 26, 2016. It has now decided to withdraw that requirement effective from December 10, 2016, completely. The Government had hiked the limit on Market Stabilisation Scheme (MSS) from Rs 20,000 crore to Rs 6 lakh crore. Under this window, RBI has mopped up Rs 1.4 lakh crore as on December 6, 2016.

There were quite a few crucial areas RBI touched upon…

NPA position based on Q2 FY17 results of banks:

  • The gross and net Non-Performing Assets (NPAs) have increased
  • Restructured advances have reduced marginally
  • Overall level of stressed assets has shown a slight uptick
  • But the incremental formation NPA decelerated
  • Provision coverage ratio has improved too
  • Relative to those in Q2FY16, recoveries have been better
  • Write-offs have as well.

The RBI has not made any particular comment on the future trend of bad assets in the aftermath of demonetisation and the slowdown in the economy.

On special dividend:

Interestingly, RBI has ruled out any possibility of announcing a special dividend, dashing the hopes of many, on account of cancellation of legal tender of currency notes. Adding to that, RBI also appealed to the citizens not to hoard currency notes. According to the central bank, hoarding rather than unavailability, has been the primary cause of the ongoing cash crunch. When asked whether or not the Government took it into confidence, before scrapping the currency; the RBI governor answered in affirmative.

On cost-benefit analysis of demonetisation:

RBI admitted that the inconvenience is the biggest cost we are paying, but it didn't forget to highlight the benefits that include…

  • Security features of new notes
  • Greater transparency
  • Fiscal and tax compliance
  • Thrust on digitalization

What has been the impact on capital markets?

While the equity markets were factoring in a 25 bps rate cut, bond markets had built in a 50 bps rate cut. Thus, the status quo maintained by the RBI came as a negative surprise. Quite predictably then equity indices slipped in red, and bond prices declined as well.

What to expect?

Reduction in the crude oil production by OPEC (Organisation of the Petroleum Exporting Countries) and firming up of oil prices in the international market may trigger inflation in India. Although, global markets have been factoring in a 25 bps rate hike by the Federal Reserve (Fed), a strict guidance about the future movement may trigger volatility in the forex market. These two factors, when put together, would have an inflationary impact on India. Nonetheless, RBI foresees the Current Account Deficit (CAD) to remain subdued.

The 6th bi-monthly monetary policy review is scheduled on February 07 & 08, 2017-post budget. By then, RBI would get more time to further assess the impact of demonetisation on the economy as a whole, with a special emphasis on inflation and economic growth. Clarity on crude oil prices and the foreign exchange movement would further facilitate the policy decision making.

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