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RBI aligns with an expansionary fiscal, but will the gains be short-lived?

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Mr.Dhananjay Sinha

Head of Research and strategist.

06 Apr 2016

The 25bp reduction in repo rate, in my view, was broadly to accommodate the market expectation and is probably indicative of the choice RBI has made to remain accommodative, notwithstanding the fact that core CPI inflation has been rising recently. Importantly, RBI has adopted an aggressive approach to address the enduring liquidity shortfall. With the articulation of an accommodative stance, the RBI seems to have aligned itself with fiscal stance of GoI (revenue expenditure growth of 12%) which attempts to boost consumption. Adoption of aggressive stimulus ahead of sufficient structural adjustments, however, could shorten the longevity of demand recovery as repercussion of higher inflation and widening external deficit re-emerges.

RBI plans extensive purchase of government securities and turning the average deficit of INR1.6bn (Q4FY16 average) to a neutral level over a period of 12-24 months. Hence, in our view in absence of adequate external flows, the RBI intends to aid transmission of lower policy rates through its interventions in the Gsec (OMO purchases) and money market. As per the change in the framework, there will be a normal incremental Reserve Money requirement of INR 200bn/month in FY17 implying a growth of 12%. In addition, with the current LAF balance of INR 1.3tn and as RBI moves towards neutrality through OMO purchase of INR 100bn/month then the neutrality will be achieved in 13 months. Overall, there is a likelihood of OMO purchase of INR 3.6 tn at the outer limit, assuming no increment in FX reserves of RBI. The risk to these assumptions are FX outflows from upcoming FCNRB redemption, continued rise in currency with public, stronger credit growth and sustenance of credit deposit wedge. Allowing banks to maintain minimum daily CRR at 90% of 4% CRR compared to 95% earlier will provide short-term liquidity relief for banks. Policy rate corridor has been narrowed down from +/- 100bp the repo rate to +/- 50bp with an intent to make overnight rate less volatile. While this measure would require forecasting of daily systemic liquidity with greater precision, contrastingly lowering of average daily CRR maintenance to 90% could impair the same. RBI maintains that the CPI inflation would decline to 5.0% from current 5.2% as it has not considered the impact of the 7th Pay commission, which has partly been adopted by the Union budget and subsequently will be adopted by state governments and PSU companies. As per RBI, full implementation of 7th Pay commission and OROP will have an impact of 100-150bp on CPI inflation. Also, the list of upside risk to inflation highlighted by RBI’s viz recent rise in commodity prices, higher government revenue spending, persistence of inflation in services sector, is much realistic and dominating than the downside risks. Clearly, RBI appears to have taken a benign view on inflation than what might be realistic. We maintain that there is indeed a case for retail inflation rate to move up by 100-150bp from current 5.0-5.5%; our conviction has been reinforced by the collected countercyclical stance adopted by government fiscal and RBI’s monetary policy stance. With nominal GDP growth assumed at 11% in the Union Budget FY17, implied GDP deflator based inflation is projected at 3.4%, higher than 1.1% in FY16. Hence, in our view, RBI’s projection of CPI inflation at 5.0% in FY17 appears too benign, especially with government focusing on boosting consumption to revive demand.RBI’s projection on growth for FY17 is kept unchanged at 7.6%, little better than 7.4% in FY16. This is pivoted on normal monsoon, consumption boost from 7th Pay Commission, OROP and accommodative monetary policy. These factors overweigh downdraft arising from fading impact of lower commodity prices on gross value added (GVA), corporate sector stress, weak global growth and tight credit standards of banks. The convergence of countercyclical expansionary approach of the RBI with the fiscal stance of the Union & state governments, in our view is ahead of completion of cyclical & structural adjustments necessary for enduring growth recovery. For instance, the declining trend in term deposit growth since FYFY09 to a 52 year low of 9.5% recently along with surge in retail lending growth to 18% indicate continued decline in financial saving rate, which has been a big drag on domestic investments, and possibly the reason why the banking system has experienced persistent liquidity deficit over most of past five years. RBI’s new framework of liquidity management or transmission of lower rates may not be helpful in this regard.Also while RBI’s enthusiasm with OMO purchases can possibly bring down investment (Gsec)/deposit ratio of banks by a 100bp from current 29%, with recent upsurge in banks credit/deposit ratio to 77% close to 2014 peak of 78% will still imply that the overall allocation of banks across credit, government securities and cash is still around 110% of deposit, implying possible persistence of liquidity shortfall. Hence, we expect spillover effects of higher inflation and widening external deficit quickly relapsing along with the short term positive multiplier effect of expansionary policies on demand. We also note that Dr Rajan has overlooked his recent precautionary view that stimulus led approach has little multiplier effect and as experiences of 2010-¬2011 indicate, the follow up repercussion of higher inflation and deficit and lower growth does not help improve the debt dynamics. Whether RBI is able to address the liquidity deficit meaningfully will depend on the movement in FX flows, rise transaction demand for money, strength in credit growth arising and sustenance of credit deposit wedge. The sustainability of RBI’s current approach will be challenged if inflation turns out to be higher than 5% (say 6.0-6.5%), INR/USD relapses into depreciation, credit demand outpaces deposit growth thereby sustaining the liquidity deficit.