Due to demonetisation, banks are already flush with funds and any rate cut may not deliver desired results
In line with market expectation, Reserve Bank of India (RBI) governor Raghuram Rajan has kept key interest rates unchanged. Rajan did not play around with the repo rate, keeping it at 6.5 per cent nor did he tinker with liquidity by keeping cash reserve ratio (CRR) unchanged at 4 per cent. However, both in the policy and Rajan’s interaction with the media, there are some interesting details on the state of the economy and RBI’s likely direction going forward.
We take a look at five key features of the RBI policy:
1) Inflation: All eyes were on how the central bank would react to rising inflation. The policy states retail inflation measured by the consumer price index (CPI) rose more sharply than expected due to a more-than-seasonal jump in food prices and stickiness of inflation excluding food and fuel. Interpreting the data RBI said the surprise in April reading makes the future trajectory of inflation somewhat more uncertain. Expectations of a normal monsoon along with various supply management measures should moderate unanticipated flares of food inflation. In addition, capacity utilisation indicators suggest that the available headroom in industry could keep output prices subdued even as demand picks up.
However, there are upside risks with firming up of international commodity prices and implementation of the 7th Central Pay Commission. Taking these factors into account, the inflation projections given in the April policy statement are retained, though with an upside bias. This could mean that the central bank could remain in the status quo mode till it gets its bias in line with its expectation.
2) Liquidity: Tight liquidity was an issue that was also hampering growth. RBI had addressed this issue in the previous policy by relaxing liquidity for banks who on account of their asset quality and tight liquidity were refraining from lending in the market. RBI’s policy states that stronger-than-usual currency demand during the first two months of the financial year and build-up of cash balances by the government from the second week of May tightened liquidity conditions from mid-May.
This resulted in RBI injecting liquidity through purchases under open market operations (OMOs) of Rs 70,000 crore. Commenting on the liquidity scenario Jayesh Mehta, India MD and Treasurer, Bank of America-Merrill Lynch said that RBI’s decision to move to liquidity neutral situation itself serves as a rate cut. He however, pointed out that liquidity situation is expected to remain tight despite RBI’s intention for the next couple of days.
3) FCNR (B) issue: A matter that is bugging the markets is the expected outflow of money on account of maturity of FCNR (B) (Foreign currency non-resident (Bank)) deposits which were encouraged in 2013 by Rajan in order to handle the falling currency during that time. Commenting on the issue, Rajan said that there may be some rupee-dollar volatility around the time of outflows but RBI is well prepared for it. Rajan said that he expects outflow of about $20 billion but pointed out that RBI has covered these in forward markets. However, there is some amount of anxiety after Rajan pointed out that some counter-parties with which the central bank had entered into forward contracts back in 2013 may not be able to deliver dollars on time.
4) Growth: Avoiding the controversial GDP numbers, the policy talks of the Gross Value Added (GVA) numbers which have grown by 7.2 per cent but saw a deceleration in services. For the current year, RBI says that there has been a seasonal pick-up in sectors like electricity. However, manufacturing remains weak on account of subdued investment demand and weak rural consumption. The policy statement is bullish on growth prospects highlighting that the latest rounds of forward looking surveys indicate an improvement in the overall business situation, driven by a pick-up in capacity utilisation and in order books – both domestic and external.
These developments have improved the expectation of business conditions in the first half of 2016-17. Public investment, especially in roads and railways, is gaining strength, though the continuing weakness in private investment is of concern. Demand conditions are likely to improve going forward; consumer confidence is seen as rising on improving expectations of employment and spending, with rural demand aided by a stronger monsoon. Rising capacity utilisation should prompt private investment.
5) On asset quality of banks: Commenting on the distressing numbers shown by banks in recent quarters after RBI asked these banks to disclose their true status of non-performing assets; Deputy Governor SS Mundra said that banks will have to further increase their provisioning coverage ratios (PCR) going forward. Without commenting on the fact if the worst is over, Rajan pointed out that in order to facilitate loan coverage norms, RBI will look to either reduce SLR (statutory liquidity ratio) or LCR (liquidity coverage ratio) for banks. This to some extent explains the rally in banks post the policy interaction.
While there has been a generally optimistic outlook on domestic growth and a slightly bearish outlook on inflation, global outlook does not seem too promising. On Britain voting to leave the Euro zone as a big global event risk, Rajan said that we have three defences – good policy, longer term liabilities and sound reserves that would help us.