After catching the market on the wrong side on two earlier occasions, the first monetary policy of the new fiscal year moved in tandem with market expectations. The Reserve Bank of India (RBI) kept its repo rate unchanged at 6.25 percent and reiterated the neutral monetary stance assumed in its previous policy in February.
The RBI has also indicated a change in its liquidity management framework, particularly management of surplus liquidity. As a result, it narrowed the liquidity adjustment facility (LAF) corridor - the difference between the repo rate and the reverse repo on one hand and marginal standing facility (MSF) and bank rate on the other (from +/-50bps to +/- 25 bps). Hence, the reverse repo rate has gone up by 25 bps to 6 percent and the MSF rate has fallen by 25 bps to 6.50 percent.
The objective of narrowing the monetary policy rate corridor is to ensure that short-term interest rates remain close to the policy rate. RBI has outlined various tools that could be deployed to achieve this goal, including variable rate reverse repo auctions with preference for longer tenors, operations under MSS and OMOs, and issuances of cash management bills. Lowering the corridor will further reduce the call money market volatility and the weighted average call money rate that remains within the LAF corridor. Also, given the surplus liquidity, banks can park surplus funds with RBI and earn a higher return.
We think the RBI has taken a very pragmatic stance based on wider market conditions. For 2017-18, inflation is projected to average 4.5 percent in the first half of the year and 5 percent in the second half. As per CSO data, RBI has pegged Gross Value Added (GVA) growth for the current fiscal at 7.4 percent as against 6.7 percent last year, based on the following emerging trends:
1. The global environment is improving, with global output and trade projected by multilateral agencies to gather momentum in 2017. Accordingly, external demand should support domestic growth.
2. Several favorable domestic factors are expected to drive this acceleration in GVA growth –
(a) The pace of re-monetisation will continue to trigger a rebound in discretionary consumer spending. Activity in cash-intensive retail trade, hotels and restaurants, transportation and unorganised segments has largely been restored.
(b) There will be significant improvement in transmission of past policy rates. Retail lending rates, in particular housing loans, have declined. However, the pressure will be on banks to pass on the same benefits to existing customers.
(c) The Union Budget has proposed large government investments and this should stimulate capital expenditure, rural demand, and social and physical infrastructure.
(d) The imminent rollout of the GST, the institution of the Insolvency and Bankruptcy Code, and the abolition of the Foreign Investment Promotion Board will boost investor confidence and bring in efficiency gains.
Downside risks to the projected growth path may come from the outturn of the south-west monsoon and oil price volatility in the international market given the situation in Syria.
Broadly, we expect lending rates to continue to remain relatively low due to surplus liquidity with banks and transmission of previous policy rates. But corporate lending is yet to pick up due to various factors, including high NPA levels resulting in limited appetite for the banking sector to lend to corporates. The policy is silent on tackling stressed assets so the RBI may perhaps delve into the issue separately.
The central bank remains committed to bringing inflation closer to 4.0 percent on a stable basis and in a calibrated manner. Accordingly, inflation developments have to be closely and continuously monitored.
Given these backdrops, RBI has taken a wait-and-watch policy. In due course of time, the central bank will have much more clarity on global factors like global growth outlook, U.S. market movements, oil price volatility, monsoon behaviour and domestic demand. Till then, we expect the neutral stance on policy rates to continue.
Kuntal Sur is Partner, Financial Services - Risk and Regulation Leader - at PwC India