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Monetary Policy Update

Feb 8, 2017

Rates unchanged at 6.25%; Shift from Accommodative to Neutral

The Monetary Policy Committee (MPC) of the RBI, kept the key policy repo rate unchanged at 6.25%; which was decided unanimously by all the 6 members.

The MPC reiterated the CPI target of 5% by Mar-17 while the medium term CPI target remains at 4% within a band of ±2%, while supporting growth. The next bi-monthly monetary policy statement is scheduled for 6-Apr-17.

The striking change was the shift in policy tone from accommodative to neutral in light of the following key factors:

  1. Potential revival in the global economy
    The RBI cited prospects of improving growth in the advanced as well as emerging economies world over. On the developed world front, U.S. (with promises of fiscal expansion) and Japan exhibited signs of improvement in H2CY16 and the Central Banks here have started to tighten conditions after lengthy periods of exceptional easing.
    On the emerging markets front, Russia, Brazil and China appear to gain health. Consequently, this has led to several indicators exhibiting upticks such as rising energy and oil prices (fueled by OPEC production cut), base metal prices and the global food index.
  2. Domestic health too appears robust barring few overhangs
    Agriculture and allied activities (aided by a normal monsoon) markedly boosted growth, though Industrial sector may have decelerated (on the back of slowdown in bank credit to industry). Services as well remained in entrenchment (per the services PMI), though the RBI noted a likely recovery ensuing with the fall in output being the least in the current phase of three consecutive months of contraction. Notwithstanding, the MPC cited several indicators such as the IIP, the output of core industries and the PMI to have returned to expansionary mode.
  3. Stickiness in domestic core CPI basket
    Excluding food and fuel, CPI has remained sticky since Sep-16 at 4.9% levels.
  4. Trade deficit shrinking
    Exports remained positive since Sep-16. Imports ex. petroleum oil and lubricants (in light of the rise in crude prices) moderated in Dec-16 vs. Nov-16. Net-net, the trade deficit shrank sequentially as well as on a yoy basis.

Outlook

  1. The outlook for vegetables prices may potentially rebound as the effects of demonetisation wear off though pulses are likely to remain soft with a comfortable supply. Excluding this, the RBI believes inflation to remain sticky and post Q1FY18 with the gap in output (i.e. pre and post demonetization levels) likely to narrow, headline CPI inflation may pick up momentum.
  2. Further upside could unfold from rising crude prices, volatility in FX and full effects of the 7th pay commission.
  3. The RBI expects a GVA of 6.9% for FY17 with upside expected in FY18 from pick up of the consumer health and cash sensitive businesses (affected from the demonetisation). The improved financial health of the banks (though stressed assets at 20% for the industry) from the flush of liquidity induced from the demonetisation has resulted in rate cut transmission which in turn should spur consumption and investments. Finally, the balanced yet expansionary Union Budget should boost growth in key areas like rural and Infrastructure. Net-net, GVA for FY18 projected at 7.4%.

Implications

The key takeaway from the RBI MPC policy meet was the change in stance from accommodative to neutral, though we would highlight that this trait did partially show its face in the prior meeting (07-Dec-16) as well when the RBI did not offer a fig leaf to the then beaten down demonetised populace.

The 10 year spiked by 30bps to 6.73% post the announcement. This decline in bond prices reflects the market’s fears of a likely end of the RBI’s rate easing stance.

However, the RBI Governor highlighted that there still remains room for further rate cut transmission as banks have cut lending rates down only 85-90bps vs. the repo rate being slashed 175bps. The current status quo policy has left maneuvering room for the RBI and it would continue to monitor the health of the economy and its path of bridging the output gap resulted from the demonetisation.

Our view on Fixed Income remains unchanged. We skew towards accrual bonds, locking in rates on a diversified portfolio of select higher yielding corporate bonds, income funds, AT-1 bonds and one off opportunities.

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