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Hawkish slant on possible deviation from fiscal rectitude

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Mr.Dhananjay Sinha

Head of Research and strategist.

02 Feb 2016

While keeping the repo rates unchanged at 6.5%, RBI elevated the upside risk to inflation corroborating my earlier view. RBI also confirmed presence of reflationary impulses from a combination of accommodative monetary stance and consumption oriented fiscal stimulus. This assessment has been reiterated in our Weekly Musings release ‘Affirmation of reflationary impulses’. In the context of our projected retail inflation of 6.0-6.5% we see little scope for rate cuts in the visible future. Clearly, with RBI remaining focused on managing liquidity gap at neutral level, the attempt is to further improve transmission of earlier 150bp rate cuts. Further, frontloading of liquidity through OMOs is an attempt to prevent market disruptions arising from FCNRB redemptions. In our view, liquidity pressure would re-emerge as credit demand picks up, multiplier impact of fiscal stimulus intensifies and potential dollar shortage

Although, RBI has stuck with a target of 5.0% CPI by Mar’17 the upside risks to inflation have been heightened in the policy statement. The cumulative impact of higher fiscal spending, recently boosted by the first supplementary grant, full implementation of Pay commission and stickiness in services inflation would result in retail inflation rising to 6.0-6.5% in the next 6-8 months. This scenario is also exhibited in uptrend in inflation expectations. Importantly, RBI statement has avoided mentioning of their earlier estimate of upside risk to inflation of 100-150bp arising from 7th CPC. We believe this risk would actually materialize. While RBI retained its growth projection for FY17 at 7.6%; the growth is likely to be arising from consumption revival based on government stimulus. Uncertainty in the global growth conditions and reflationary approach adopted by many economies such as Japan, China etc is likely to overcast uncertainty on the Indian domestic growth story.

Seasonality factor such as a) sharp reduction in government cash balances (from INR 343.8bn in Mar’16), b) frontloading of OMO purchases of INR 800bn to prevent disruptions in the event of FCNRB redemptions, c) higher government expenditure (18.8%YoY in Q1FY17) have expunged reduced liquidity deficit from as high as INR2.5tn to a surplus of INR500bn. It is on the back of such transitory factors yields across tenors have eased down by an average 67bps from Feb’16. However, RBI’s liquidity interventions have not yet been able to revive the deposit growth, which at 9.5% remains at a 52 year low. Hence, we believe as credit demand revives on the back of reflationary impulses the transitory ebbing of liquidity pressure wears off. RBI has clearly highlighted that the growth impetus is likely to be emerging from reinvigoration of aggregate demand through accommodative monetary policy stance and nature of government spending. This is in conjunction with our earlier prognosis of a reflationary growth approach since Jan’16. We are already witnessing the impact of increase in government consumption on inflation, revival in corporate sales growth and on consumer durables growth. With further enhancement in government revenue spending we expect further fortification of these trends. Although transitory factors have reduced the liquidity deficit, the structural shortfall still persist; financial saving of households still remains weak (fixed deposit growth of ~9% is much lower than +20% growth in retail lending) and CD ratio of banks at 75.1% hasn’t declined adequately. Looking beyond the transitory factors, we believe that in a scenario of higher credit demand, rising US 10Yr yields and elevated inflation, Gsec yields could harden going forward.