Third Bi-Monthly Monetary Policy – R3’s Final Move

The Reserve Bank of India, will announce its third bi monthly monetary policy for the year on Aug 9,2016. This policy review shall be the final move from Dr. Rajan (R3 – RaghuRam Rajan) – the man in the hot seat for the past 3 wonderful years. Will it be a rate cut, a status quo or a rate hike in anticipation to the current economic and global conditions? Lets take a glimpse at the domestic conditions and the global economic conditions as well to assess the probable outcome of the monetary policy on the coming Tuesday. We will discuss the current scheme of things with the monetary policy, various domestic parameters, monetary policy transmissions – improvements and finally what would be the outcome of the monetary policy this time.

A quick background of the current stance in terms of the rates – CRR at 4%, SLR at 21%, Repo Rate at 6.5% (stagnant at that stage for quiet a while now) and the rupee has been hovering in the range of 65-67. On the global front, the Federal Reserves have kept their rates unchanged as well for a significant time span. The Bank of England was witness cutting the lending rates from 0.5% to 0.25% last week. Generally, when the interest rates are near zero levels, if a central bank chooses to cut it further, it essentially signals that the growth is stunted and the central bank wishes to spur the same to the extent possible without using any unconventional monetary measures.

A lot has happened since the past 3-4 months – the Brexit and its global effects, the gradually syncing fear of another global meltdown with most of the advances economies unable to exit the recession ill effects. India, although has been stable so far, cannot afford to think yet another time that we are decoupled from the global turmoil. Being emerging nations, we will be affected by the global downturn if the right measures are not in place. The global conditions are signaling a more accommodative and stable monetary stance (which essentially means a status quo).

On the domestic front, the headline inflation has been inching northwards from the past 3 months. This aspect would definitely get Dr. Rajan worried since the inflation targeting regime would be breached in case the inflation keeps increasing with the persistent rates. The CPI inflation has been hovering around 5.5-5.7% levels lately, however the same going anywhere beyond 6% would have an impact on the consumption and demand growth in the near future. With the target of maintaining the average inflation at 4% by Jan 2017, this monetary policy stance should be a status quo. Food inflation, although increasing at a decreasing rate, should essentially provide some relief for the central bank. The rainfall also has been fairly above the average levels compared to the previous 3 years.

With the auto-regressive integrated moving average predicted forward curve shows a probably uptick in the inflation rates as shown below. RBI would want to wait and watch for the inflation numbers to be published on the 12th of August before they create a case for a rate cut.

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Wholesale price index which was showing deflationary trends in the previous quarter has now started to head northwards sharply in the past 3 months. As far as the inflation metrics are concerned, it certainly reemphasizes a status quo in this monetary policy review.

On the growth front, Index of Industrial Production has shown clear signs of stagnancy so far, but the central bank seems to be hopeful about the revival in the next two quarters since the rate cuts will kick in with a lag. However, the Q2 earnings of most companies have been satisfactory amidst such global turmoil in the rest of the advanced economies. With IIP slowing down, it might act as a key parameter in deciding the policy actions this time. The downward trend however indicates a case for a 25bps rate cut sometime before the end of 2016. Here’s a quick look at the IIP and the forecast so far:

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The currency markets being in turmoil, the rupee has managed to perform significantly better than the rest of the emerging economies, especially against the dollar. I feel, the RBI has create significant foreign currency reserves in order to deal with the turmoil in a much robust way that ever before. With no requirement to stabilize the currency from policy actions, it indicates a status quo as well.

Banking sector, however, has been still struggling with the asset quality. The loan growth still is unable to surpass the barrier of 12% levels, whereas the deposit growth stands at 11%. However, we must appreciate the fact that the inflation targeting regime has been managed efficiently and the loan growth rate has been taken care of simultaneously as well. Although, the loan growth seems subdued, RBI still has room to take hits on the same for a few more months and wait for the global unrest to stabilize. A quick glimpse at the loan growth will indicate the improvements and the forecasts as well:

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The call money markets and the inter bank lending rates have shown a fairly stable nature. The indication of stability of these rates is when they do not break the 200 bps window created by the RBI by setting the repo rates. For the readers: Repo rate is at 6.5%, in order to conclude that the call money rates are stable, they need to be between the 6% (Current Reverse Repo Rate) and 7.0% (Current MSF rates/ Bank Rate) corridor. This corridor usually used to be 200 bps when the liquidity conditions were tight. In case, they break either levels, it calls for a interest rate action to accommodate the change. The current scenario indicates that there is absolutely enough liquidity in the system and no action whatsoever is required by the central bank via the monetary policy tools. A quick glance at the IBLR and its forecast:

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Inefficient monetary policy transmission has been creating hindrances for RBI from a year now in terms of passing on the benefit to the customers. The RBI has reduced the repo rate by over 125bps yet the banks seem to have passed on the rate cuts only to the tune of 60-70 bps. The reason being, the stressed assets and the intense pressure on profitability due to increasing costs and provisions. In order to address this, the RBI asked the banks recently this year to shift their calculations of cost of funds to a efficient method called as the marginal cost of funding. Since then, the banks have implemented the same and a few of them have managed to pass on the benefit of another 5-10 bps recently. Although, the results have been evident, the transmission is going to be a key concern for the RBI in the coming period as well.

Considering the average CPI at 6% and the repo rates at 6.5%, ERI is hovering around 0.25-0.5%  which might affect the growth in the coming future. Although, the ERI is much lower than the RBI comfort zone of 1-1.5%, this might not act as a trigger for a rate cut since taming inflation shall hold priority. However, it does call for a rate cut sometime this year to increase that ERI window to 1% at least.

To sum up, the domestic conditions for growth are improving gradually, mainly driven by consumption demand, which is expected to strengthen with a above average monsoon and the implementation of the Seventh Pay Commission award. Higher public sector capital expenditure, led by roads and railways, should crowd in private investment, offsetting somewhat the subdued requirement for fresh private investment due to financial stress. Yet, business confidence will be restrained to an extent on account of uncertain global factors for the next 6 months at least.

What does all of this mean for the upcoming monetary policy?

It is needless to say that the global economy is under significant pressure. Certainly, the solution does not seem to lie in the monetary sphere at the current moment. I predict, that the RBI might hold the repo rates at the current levels of 6.5%. CRR and SLR might also be untouched due to the ample amount of liquidity and money supply in the system. But witnessing the current conditions and the forecast, RBI might have to step on the gas in the next review with a rate cut of 25 bps. However, the tone of the policy would continue to be fairly dovish and reform driven. However, RBI shall continue to keep its inflation targeting focused until it is tamed to a consistent 4% levels by 2017.

Thank you. 🙂

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