Moneycontrol
Dec 07, 2016 02:32 PM IST | Source: Moneycontrol.com

RBI Monetary Policy: Rate cut likely as India battles demonetisation

The RBI, guided by the newly-formed six-member monetary policy committee (MPC), is widely expected to cut its key lending rate — the repo rate — by 25 basis points to 6 percent.


Gaurav Choudhury
Moneycontrol


If you have a home loan, plan to buy a car or need more funds to add capacities in your factory, you would probably be keenly following what the Reserve Bank of India (RBI) announces on Wednesday.


RBI Governor Urjit Patel will present his second monetary policy review in the midst of the “demonetisation” exercise that has disrupted individuals and businesses alike.


The RBI, guided by the newly-formed six-member monetary policy committee (MPC), is widely expected to cut its key lending rate — the repo rate — by 25 basis points to 6 percent.


The MPC’s decision will be likely influenced by two factors: (a) the fall in consumer and investment spending because of the currency drain out, and (b) the outlook on inflation and the rupee’s value.


In recent history, rarely has a single policy decision in the financial world had such an immediate impact as India’s move to retire old Rs 500 and Rs 1,000 currency notes.


While India, at 7.3 percent growth in July-September, remains the world’s fastest-growing major economy, ahead of 6.7 percent growth in China that is battling an industrial deceleration, question marks remain over its ability to hold on to that status following the demonetisation drive.


The move has curtailed consumer spending as households adjust to the new system.


This delay in household spending could push back investment growth with firms already sitting on vast unused capacities in consumption-linked sectors.


Capital goods output, a metric to gauge capacity additions by companies, have contracted for 11 successive months mirroring faltering investment activity.


A cut in the repo rate, the rate at which the RBI lends to banks, should ideally bring down banks’ borrowing costs, eventually leading to lower loan rates for companies and individuals.


Inflation outlook


India’s inflation rates have remained well within the RBI’s tolerable threshold limit of 6 percent. It was 4.20 percent in October, and should remain within the manageable range on fresh arrival of seasonal vegetables.


That said, there are two unknowns on the inflation front: fuel prices and the “demonetisation” effect.


Most analysts expect fuel prices to rise from January after the Organisation of Petroleum Exporting Countries (OPEC) — a cartel of oil producers — agreed to cut back production from the beginning of 2017.


The resultant fall in supplies should push up crude oil prices from its current historic lows, eventually leading to higher diesel and petrol pumpgate prices in India.


This, in turn, could fan overall inflation rates, limiting the RBI’s ability to cut interest rate further.


There is no proxy to measure how demonetisation will affect food and other prices.


The move has affected sowing plans for the rabi (winter) season. The economy-wide drain-out of the old notes has also left many farmers with no cash to buy seeds in the middle of the sowing season. This could have a bearing on food supplies and prices, a fact the MPC may scrutinise.


Rupee risks


The RBI and the MPC will also have one eye on the rupee’s movements.


The rupee has been persistently flirting with its record low levels, with analysts forecasting that it could breach the 69-70 to-a-dollar mark in the coming months.


Depositors have begun withdrawing money parked in foreign currency non-resident (FCNR) deposits.


Banks had raised these funds through specially created three-year FCNR schemes in 2013 to shore up dollar supplies and arrest the rupee’s slide in 2013.


These deposits are now due for redemption. The central bank expects about USD 20 billion to be withdrawn from these special FCNR deposits.


The resultant demand for dollars could depreciate the rupee’s value.


Also, the US Federal Reserve will meet next week amid speculation that it would raise interest rates aided by strong revival signs in the world’s largest economy.


Higher interest rates will make the US markets more attractive for foreign investors. This could prompt funds to move funds quickly from emerging markets such as India to the US in expectation of higher returns in the months to follow.


This could knock down the rupee, making the RBI hesitant to cut interest rates to maintain India’s attractiveness as a favoured debt market for foreign funds.


Excess liquidity


The central bank has to also deal with a problem of plenty.


The unexpected surge in demonetisation-induced liquidity has forced the RBI to temporarily ask banks to park the entire amount of cash as 100 percent cash reserve ratio (CRR) with the central bank.


A status quo on this measure could discourage banks to cut lending rates.

Banks don’t earn interest on CRR and, therefore, don't want to set aside funds for this pool, which effectively is an idle asset.

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