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Monetary Policy Update

Apr 6, 2017

Repo rate unchanged at 6.25%

The Reserve Bank of India today decided to keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.25% which was decided unanimously by all the 6 members. The decision was consistent with maintaining a neutral stance on monetary policy and achieving a medium-term target for CPI of 4% ± 2%, while supporting growth.

However, the LAF Corridor was narrowed from prior ± 50bps to ± 25bps to ensure finer alignment of the WACR (weighted average call rate – the operating target of the monetary policy) with the repo rate and hence manage liquidity better. Consequently, this has led to a hike in the reverse repo rate to 6% from earlier 5.75%.

Key highlights

Stronger Developing Market Growth:

  • Indicators of global growth suggest signs of stronger activity in most advanced economies and an improvement of recessionary conditions in large emerging economies, for instance, Brazil.
  • In the U.S., the data suggests a pickup in labor markets, industrial production and retail sales, while in Europe, PMI is at a six-year high with improving consumer confidence and employment conditions. An improvement in conditions signaling a recovery of sorts is evident in Japan as well.

Emerging Markets Outlook Improving:

  • Surging credit growth and a booming property market are keeping momentum stable in China, despite concerns about debt and financial outflows.
  • Global trade volumes are finally showing signs of improvement, with exports rising strongly in several emerging markets.

Inflation Risks: As a result of the potential uptick in global economic health, inflation is showing signs of edging up in several advanced economies on the back of rising commodity prices and tightening labor markets.

Improving Domestic Outlook:

  • Food grain output has touched an all-time high of 272m tons, with record production of rice, wheat and pulses. This bumper production will help build up the stock buffer and contribute to keeping food inflation in check. However, investment and rural consumption remain muted.
  • Sentiment and prospects look to be improving: Activity in the services sector also appears to be improving, with notable strength in tourism, passenger and commercial vehicle sales, and traffic. After three consecutive months of contraction, the services PMI for India for February and March emerged into the expansion zone on improvement in new business. The IIP and Manufacturing PMI have remained strong as well. Core CPI (ex food and inflation) has also started to moderate, declining -20bps to 4.8% in Feb-17 (vs. “sticky” nature highlighted in the Feb-17 MPC call). For fuel, the MPC guided towards a nearly 2-month lag in international prices passing through to the CPI.
  • Real Estate: The RBI will also issue guidelines allowing banks to invest in REITS and InvITs by May-17.

Liquidity: With the progressive increase in remonetisation, the RBI seems to have the liquidity glut post demonetisation under control. Additionally, it also remains committed to managing liquidity via various instruments in their tool kit such as MSS, long as well as shorter term variable rate reverse repo operations, a nimble OMO if necessary and others.

Outlook

  • CPI: The RBI expects CPI to average 4.5% in H1FY18 and 5% in H2FY18.
  • GOI Spending: The Government is expected to increase its spending in FY18 with significant front-end loading expected in H1FY18.
  • The RBI has highlighted plenty of upside risks to domestic economy ranging from uncertainty from El-Nino, 7th CPC allowances and GST, with measured downside risks in the form of pass-through of recent Crude reduction and healthy supply of food grain stocks.
  • Net-net, GVA growth is projected to strengthen to 7.4% in 2017-18 from 6.7% in 2016-17.

Key Implications

Ten-year yields spiked to 6.77% by the close of the day which we believe likely reflects markets’ fixation on the:

  • Government’s focus on the plentiful upside risks to inflation,
  • Its financing program with spending increase in H1FY18 and the additional burden from the announced farm loan waivers and
  • Narrowing of the LAF corridor (and subsequent reverse repo hike) which could potentially curb the absorptive power of the RBI and resultantly leak into inflation though Mr. Acharya mentioned that at the moment, the WACR is within the LAF corridor.

The INR has strengthened nearly 3% over the last month as a result of the liquidity management by the RBI which though does dampen exports. Net-net, we expect yields to remain rangebound until further clarity emerges on the government’s financing program.

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