As widely expected RBI maintained a status quo on key policy rates. The Repo rate stands at 6.25%, the Reverse repo rate at 6% and the Marginal Standing Facility (MSF) rate and Bank rate at 6.50%. Five members of the MPC were in the favour of the decision, while Mr. Ravindra Dholakia was not in favour.
The RBI was surprised with the low inflation reading for April (CPI at 2.99%) vis-à-vis the rising trajectory witnessed in February (3.7%) and March (3.9%). And it would like to assess whether the unusually low momentum in the reading for April will endure. Lower food inflation, particularly a fall in prices of pulses, due to a supply glut caused by a record output and imports, was a key driver of the lower inflation print in April. Policy interventions could be envisaged to arrest the slump in prices. Further, the accumulated downward adjustment in the prices of petrol and diesel affected in April has been largely reversed in June, indicating that the inflation readings for June and subsequent months would be impacted by the higher fuel prices. It also believes that the easing of core inflation (inflation excluding food and fuel) in April (4.53% vs 4.9% in March) may be transient in terms of its stickiness in a situation of rising rural wages and strong consumption demand. Although, elsewhere in its statement, the RBI indicates a lack of pricing power with corporates. Thus, the April reading has imparted significant uncertainty to its inflation trajectory particularly in the near term.
On the assumption that the factors driving the April inflation reading continue going ahead, the RBI has revised its inflation trajectory downward. Headline inflation is now projected in the range of 2% to 3.5% in the first half of the year (vis-à-vis an average of 4% projected in the April policy) and in the range of 3.5% to 4.5% in the second half (vis-à-vis the earlier projected level of 5%). The risks to this view are evenly balanced (which is a change in view expressed in April when upside risks to inflation were indicated). Key risks mentioned include the spatial and temporal distribution of the monsoon and the government staying the course in effective food management. It also highlighted that the risk of fiscal slippages has risen, which can result in inflationary spillovers, with the announcements of large farm loan waivers (if they cause higher government borrowings). Global political and financial risks materializing into imported inflation (possibly on account of a stronger dollar and higher commodity prices) along with a disbursement of allowances under the 7th central pay commission award were identified as other upside risks. Base effects, due to higher inflation levels in the period from April to August’16, would also wear off post August’17, contributing to an uptick in inflation from September’17 onwards. With the announcement of GST rates for various goods and services, the RBI believes that there will be no material impact on headline inflation.
In terms of growth, the RBI has lowered its GVA projections for 2017-18 by 10bps vis-à-vis its April projections, to 7.3% in line with the lower growth estimates for 2016-17 announced by the CSO recently (6.6% in FY17 vs 7.9% in FY16). Key growth drivers include continuing remonetisation enabling a pick-up in discretionary consumer spending, lower bank lending rates supporting both consumption and investment demand of households and stress free corporates. Robust government spending is expected to cushion the impact of a slowdown in other segments and the implementation of proposals in the Union Budget should crowd in private investment as the business environment improves with structural reforms such as GST, etc. On the downside, global political risks remain elevated and could materialise. Rising input costs and wage pressures could be a drag on corporate profitability, pulling down overall GVA growth. Finally, the twin balance sheet problem – over leveraged corporate sector and stressed banking sector – may delay the revival in private investment demand.
Going ahead the RBI believes that underlying inflation pressures, especially input costs, wages and imported inflation will have to be closely and continuously monitored. Noting that inflation has fallen below 4% only since November 2016, the Monetary Policy Committee (MPC) remains focused on its commitment to keeping inflation close to 4% on a durable basis keeping in mind the output gap (i.e. growth expectations). Further, it stated that the current state of the economy underscores the need to revive private investment, restore banking sector health and remove infrastructure bottlenecks (areas in which the government needs to increase focus). And that monetary policy can play a more effective role when these factors are in place. As a rationale for maintaining its neutral stance, it stated that premature action at this stage risks disruptive policy reversals later and the loss of credibility.
Impact on overall economy
With the RBI continuing to hold policy rates at current levels and the surplus liquidity in the banking system, bank lending rates would continue to remain low and supportive of growth. Implementation of RBI’s liquidity management framework as announced in April and its impact on interest rates would need to be monitored. A broad based and sustainable economic recovery is also contingent on a revival in private capital expenditure, which as highlighted by the RBI, requires a restoration of banking sector health and removal of infrastructural bottlenecks jointly with the government. Separately, the RBI also announced a lowering of risk weights and provisioning requirements on individual housing loans to spur demand in that sector. It also announced a reduction in the Statutory Liquidity Ratio (or SLR) maintained by Banks by 0.5% to 20% from 20.5%. This was done in order to give greater flexibility to banks to comply with the minimum Liquidity Coverage Ratio (LCR) in an efficient manner.
As stated in our April policy note, going ahead the RBI would continue to monitor incoming data on inflation and growth prior to changing the policy rates. If inflation were to remain benign below 4% levels over the next 3 to 4 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 softened by 20 to 25 bps since release of the April inflation data last month and subdued GDP growth nos. recently, with a further 8 to 10 bps fall after the policy announcement today (the new 10 year GSec ended at around 6.56%). FPI flows into fixed income markets continue to remain strong (USD 2.9 bn in May and USD 10bn CYTD) and support yields at lower levels.
A review of our long-term capital market assumptions (or CMAs) including risk & 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.
