RBI shifts gears to Neutral

Morningstar India's Investment Adviser team looks at the impact of the monetary policy on the economy and its model portfolios.
By Morningstar Analysts |  07-04-17 | 

The RBI in its first bi-monthly monetary policy review of the fiscal kept the policy repo rate unchanged at 6.25%, as widely expected and re-iterated the neutral monetary stance assumed in its previous policy in February 2017. Importantly, it narrowed the Liquidity Adjustment Facility (or LAF) corridor or the difference between the repo rate on the one hand and the reverse repo and marginal standing facility (MSF) & bank rate on the other, from +/-50bps to +/- 25 bps. Hence, the reverse repo rate has been increased by 25bps to 6% and the MSF rate has been reduced by 25bps to 6.50%. The CRR was left unchanged at 4%. It also re-iterated its objective of achieving the medium-term target consumer price inflation (CPI) of 4% within a band of +/- 2%, while supporting growth.

The RBI has also indicated a change in its liquidity management framework particularly the management of surplus liquidity. The RBI is now committed to reverting system liquidity to a position closer to neutrality, consistent with its stance of monetary policy. It has outlined various tools that could be deployed to achieve this goal – including variable rate reverse repo auctions with preference for longer tenors, operations under MSS and OMOs – sales and purchases – and issuances of cash management bills (or CMBs).

Broadly, RBI believes that growth in advanced economies is showing signs of stronger activity and recessionary conditions in commodity linked emerging economies are receding. On the domestic front, several economic indicators are pointing towards a modest improvement in the macroeconomic outlook including higher food grain production, IIP for January and manufacturing PMIs for February and March. RBI’s latest industrial outlook survey indicates that overall business sentiment is expected to improve in Q1 2017-18 on the back of a sharp pick-up in both domestic and external demand. Although, it observes that the sizable under-utilization of capacity in several industries could operate as a drag on investment. Activity in the services sector also appears to be improving as the negative effects of demonetization wear off. After three consecutive months of contraction, the services PMI for February and March emerged into the expansionary zone on improvement in new business.

Overall, in terms of its growth outlook and in line with expectations outlined in the February policy, the RBI projects GVA growth to strengthen to 7.4% in 2017-18 from 6.7% in 2016-17, with risks evenly balanced. Several domestic factors are expected to drive this acceleration, including the pace of remonetisation triggering a rebound in discretionary consumer spending, significant improvement in transmission of past policy rate reduction into banks’ lending rates helping encourage both consumption and investment demand, proposals in the Union Budget, expected roll-out of the GST and other reform measures undertaken by the government.

In terms of inflation, the RBI believes that headline CPI is expected to undershoot the target of 5% for Q4 2016-17 in view of the sub-4% readings in January and February. For 2017-18 inflation is projected to average 4.5% in the first half of the year and 5% in the second half. Risks are evenly balanced around the inflation trajectory at the current juncture. The upside risks to the baseline projection include the possibility of El-Nino negatively impacting the monsoon, implementation of the allowances recommended by the 7th Central Pay Commission (expected impact of HRA is 100 to 150bps on inflation over 12 to 18 months), one-off effect of GST and rising commodity prices. On the downside, recent easing of international crude prices and their pass through to domestic prices of petroleum prices should alleviate pressure on headline inflation.

Impact on overall economy

Broadly, lending rates continue to remain relatively low due to surplus liquidity with banks and transmission of previous policy rates. But corporate lending is yet to pick-up due to various factors including high NPA levels resulting in limited appetite for the banking sector to lend to corporates as well as low demand for credit from corporates on account of under-utilization of existing capacities. The RBI has highlighted the importance of resolving the bad asset problem jointly with the government and has outlined measures in this policy as well.

The objective of narrowing the monetary policy rate corridor is to ensure that short term interest rates remain close to the policy rate. This would result in short term rates moving up by 25 to 30 bps. In our view, if inflation were to rise and remain in a range of 4.5% to 5% over the next 6 to 12 months, as projected by the RBI, it may consider various monetary policy measures including tightening liquidity further and raising rates to bring inflation to its target level of 4%. On the other hand, if inflation were to remain benign below 4% levels over the next 3 to 6 months, the RBI may not reduce rates immediately unless it expects a significant deterioration in growth prospects.

Morningstar Model Portfolios

Yields on longer dated securities have remained volatile since RBI changed its stance in February, with the 10-year G-Sec moving in the range of 6.50% to 6.90%. The last few weeks have seen substantial FPI inflows into the fixed income markets resulting in a marginal softening in yields. We are in the process of reviewing our positions in long duration funds and would take a view shortly. A review of our long-term capital market assumptions (or CMAs) including risk and return estimates for various asset classes has been recently completed, based on which the asset allocation and underlying holdings would be reviewed by end of the June quarter.

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