Monetary Policy: Expect repo rate cut of 25 bps & transition to MCLR regime

Aditi NayarICRAThe Reserve Bank of India (RBI) had kept the Repo rate unchanged at 6.75% in the final bi-monthly monetary policy review for 2015-16, awaiting clarity pertaining to the fiscal stance and structural reforms that the Union Government would adopt in the Budget for 2016-17. The RBI’s expectation of a mild pickup in growth of GVA at basic prices to 7.6% in 2016-17 from its projection for 2015-16 of 7.4% with a downward bias had also supported the status quo.ICRA anticipates a 25 basis points (bps) reduction in the Repo rate in the RBI’s April 2016 monetary policy review, based on our expectation that CPI inflation for March 2016 would print close to the Central Bank’s target of 5.0% for March 2017 and the reiteration of the Union Government’s commitment to fiscal consolidation in its Budget for 2016-17. Furthermore, we expect monetary transmission to improve following the recent reduction in various small savings rates as well as the implementation of the new Marginal Cost of Funds based Lending Rate (MCLR) regime by banks with effect from April 1, 2016. CPI inflation eased to a four-month low 5.2% in February 2016 from a 17-month high 5.7% in January 2016, led primarily by food inflation, which declined to 5.5% in February 2016 from 6.7% in the previous month. However, core-CPI inflation hardened somewhat to 5.0% in February 2016 from 4.7% in January 2016. ICRA expects headline CPI inflation to ease further in March 2016, led by both food and core inflation, and print close to the RBI’s target of 5.0% for March 2017. This would support the case for a 25 bps cut in the Repo rate in the April 2016 policy review. However, front loading of a larger cut in the Repo rate may not be warranted, partly on account of the risks to the inflation trajectory posed by factors such as the expected pickup in consumption demand post the rollout of the Seventh Central Pay Commission’s award as well as the eventual monsoon outturn. The Central Bank may prefer to reassess the space for further rate cuts once greater clarity emerges regarding the impact of such risks on the inflation trajectory.The Union Budget for 2016-17 has reinforced the GoI’s commitment to fiscal consolidation. The GoI did not deviate from the fiscal deficit of 3.9% of GDP targeted in the Budget Estimate (BE) for 2015-16, despite the adverse impact of lower-than-expected GDP growth, and the substantial shortfall in disinvestment inflows and direct tax revenues. Moreover, the BE for 2016-17 adhered to the previously announced fiscal deficit target of 3.5% of GDP, in spite of the constraints imposed by the higher outgo on pay and pensions.Post the recent review by the Ministry of Finance, the 25 bps spread over Government security (G-sec) rates of comparable maturity for certain small savings schemes (1-, 2- and 3-year term deposits, KVPs and 5 year recurring deposits) is being removed from April 1, 2016. Furthermore, in line with the average G-sec yields in December 2015-February 2016, various small savings rates are being reduced by a substantial margin from April 1, 2016. Since small savings pose competition to bank deposit mobilisation, the cut in their interest rates would improve transmission of past Repo rate cuts to bank deposit rates. Moreover, interest rates for small savings schemes are now to be recalibrated on a quarterly basis, which would make them more market-aligned and reduce the impediments to monetary transmission that have been highlighted by the RBI in the past. Additionally, the implementation of the new MCLR regime by banks with effect from April 1, 2016 is likely to improve the efficiency of monetary policy transmission for new borrowings. Complete transmission to lending rates would be linked to the extent of reduction in term deposit rates as well as the proportion of term deposits in the overall funding profile of banks. For instance, if a reduction in banks’ deposit rates matches the repo rate reduction and term deposits constitute 60% of the funding, reduction in MCLR would be limited to 60% of the repo rate cut.Following the expected 25 bps cut in the Repo rate in the April 2016 policy review, ICRA expects banks to promptly reduce their deposit rates, particularly given the reduction in small savings interest rates, which would transmit to lower lending rates by May 2016 under the new MCLR regime.