Beyond the rate cut call, there are questions which at the current juncture can be very important. Answering these crucial questions will provide some reassurance to the markets and the economy in general.
The December 7 credit policy assumes special significance against the backdrop of the demonetization announcement on November 8, 2016. The RBI has been mostly silent since then barring the regular notifications and press releases. The policy gives it an opportunity to outline its thoughts and inform the public on the implications of demonetization for the economy.
The Monetary Policy Committee (MPC) is meeting at a time when myriad issues have come to the forefront: (1) canceling legal tender of Rs500 and Rs1000 denomination notes, (2) spiking of global bond yields sharply and (3) weakening of INR due to a combination of domestic and global factors. The call on the repo rate should take into cognizance risks of growth slowdown, comfort on inflation and risks of INR volatility from sharp contraction in real interest rate differential. We believe the RBI will exercise caution in its December policy and reduce repo rate by 25 bps. This will support growth dynamics without any significant risks of adverse FX dynamics.
Demonetization and short term risks to the economy
The government cancelled legal tenders of Rs500 and Rs1000 denomination notes on November 8, 2016 to replace them with new Rs500 and Rs2000 notes. The currency in circulation has got progressively lower with (1) limits on bank withdrawals and (2) supply constraints in injecting the new notes, especially of Rs500 in branches and ATMs. The net short term effect of demonetization is a sharp slowdown in economic activity as cash transactions have suffered. Business, especially in the unorganized segment, has been hit. This could have knock-on effects depending on the duration of cash constraint in the economy. 3QFY17 and to some extent 4QFY17 will suffer lower-than-normal economic growth. We estimate that 2HFY17 growth to be around 5.7%—much lower than our pre-demonetization estimate of around 7.4%.
Lower growth in effect increases the output gap and opens up room for the RBI to support growth without necessarily concomitant inflationary risks. Further, in the short term, the fiscal space may not be geared to providing any impetus to growth. This puts the responsibility squarely on the RBI to reduce rates and offer some support to the economy. The RBI will have the comfort of recent inflationary trends remaining below its own expectations. We should note that market rates have already dropped due to the liquidity glut in the system and minimal avenues available to channel banking liquidity to productive credit creation. With inflation close to 4.5%, the RBI can reduce rates, in line with 1-1.25% of real interest rate and 3-month T-bill rate of around 5.9%. We expect the RBI to reduce repo rate by 25 bps conditioned on maintaining a balance between (1) growth-inflation dynamics post demonetization and (2) concerns on FX from a generalized weakening of EM currencies and steady contraction in India’s real interest rate differentials.
A few important questions
Beyond the rate cut call, there are questions which at the current juncture can be very important. Answering these crucial questions will provide some reassurance to the markets (and the economy in general). (1) What is the status of printing notes especially of Rs500? (2) What is the capacity of the mints for printing notes? (3) What is the short term impact on the economy (growth, inflation, and money supply)? (4) How does the RBI view the liquidity situation?
The RBI may not necessarily answer all of them given the nature of its operations. But, the nub of the policy will be beyond the ambit of just monetary policy. The credit policy has traditionally seen the RBI’s role as the monetary authority and regulator of the financial system. It will possibly be as important to see the RBI in its role as the issuer of currency, even if it is not a part of the policy communique on December 7.
The author is Senior Economist at Kotak Institutional Equities.