There is a high likelihood of a 25 bps cut in the repo rate.
Growth of gross value added (GVA) at basic prices remained steady at 7.2% in H1 FY2017, in line with the trend in the first half of the last fiscal. The subsequent withdrawal of the legal tender status for the existing notes of Rs. 500 and Rs. 1,000 from November 9, 2016 onward, accounting for over Rs. 14.5 trillion, and more than 85% of the value of bank notes in circulation, is expected to curb illegal transactions, decrease the prevalence of black money and reduce the dependence on cash over the medium term. However, the crunch in cash liquidity has diluted consumer confidence, which would dampen growth of consumption, corporate earnings and indirect tax revenues in Q3 FY2017. Moderate capacity utilisation levels suggest that private sector investment decisions may get deferred further. The pace at which cash liquidity improves and people switch to cashless transactions, would crucially impact growth in H2 FY2017.
In contrast, weaker economic sentiments would dampen inflation, particularly for discretionary items, resulting in a further decline in CPI inflation to ~3.6% in November 2016, from the 14-month low 4.2% in October 2016. Following the OPEC agreement, a rise in the average crude oil price to ~US$55/barrel in the remainder of this fiscal from the average of ~US$ 45/barrel in April-November 2016, would have a first round impact of raising average CPI inflation by around 20 bps in December 2016-March 2017. Nevertheless, the moderation in demand is likely to ensure that the CPI inflation undershoots the Reserve Bank of India’s (RBI’s) March 2017 target of 5.0%, allowing for stimulus by way of further monetary easing of 50 bps up to June 2017.
ICRA expects the RBI’s Monetary Policy Committee (MPC) to pare its baseline GVA growth forecast downward from 7.6%, during its second meeting to be held in December 2016. While retaining the interim CPI inflation target of 5.0% by March 2016, the MPC is now likely to view risks as tilted to the downside.
The RBI has indicated that between November 10, 2016 and November 27, 2016, Rs. 8.1 trillion was deposited into banks, Rs. 0.3 trillion was exchanged into new currency notes, and Rs. 2.2 trillion was withdrawn from bank accounts. With limited demand for incremental lending, higher inter-bank liquidity led banks to deposit excess funds with the RBI at its reverse repo window, and purchase Government securities (G-sec). The latter led to a sharp correction in bond yields, which would benefit new borrowers. Moreover, the concomitant increase in G-sec prices would result in considerable treasury gains for public sector banks.
Higher deposits were expected to lower the cost of bank funds and transmit to softer lending rates. However, the temporary hike in cash reserve ratio (CRR) instituted by the RBI on the incremental net demand and time liabilities (NDTL) between September 16, and November 11, 2016, impounded Rs. 3.4 trillion of deposits. With this change, the banks would not earn anything on those deposits, while continuing to pay interest on them, thwarting transmission.
However, the ceiling for the market stabilisation scheme (MSS) has now been hiked to Rs. 6 trillion. This, in conjunction with the RBI’s stock of G-sec in excess of Rs. 7 trillion, suggests that the CRR hike may no longer be required to absorb excess liquidity. Therefore, ICRA expects the temporary CRR hike to be reversed in the upcoming policy review, along with a timeline for issuance of securities under the MSS.
If the Government and the RBI intend for the economy to transition to a lower currency to GDP ratio and a larger percentage of non-cash transactions, then banks' deposits may remain elevated over the next quarter. Given this structural shift, open market sale of G-sec may be an appropriate tool to permanently absorb liquidity, rather than using those bonds as collateral for overnight or term reverse repos.
In our view, there is a high likelihood of a 25 bps cut in the repo rate in the upcoming policy review, which would support sentiments amidst the temporary economic slowdown. This, in combination with clarity on liquidity management, would be a signal for banks to lower deposit and lending rates, protecting their own net interest income and also benefiting borrowers.
The author is Principal Economist at ICRA