Highlights of RBI’s Third Bi-monthly Monetary Policy Statement, 2016-17

Policy Measures

* Repo rate unchanged at 6.50 per cent, Reverse Repo at 6%, Bank rate and MSF rate at 7%

* Cash reserve ratio or CRR unchanged at 4%

*Continue to provide liquidity as required but progressively lower the average ex ante liquidity deficit in the system from one per cent of NDTL to a position closer to neutrality

Assessment

Since the second bi-monthly statement of June 2016, several developments have clouded the outlook for the global economy. Q2 growth has been slower than anticipated across AEs, with the Brexit vote increasing uncertainty. Among EMEs, activity remains varied. GDP growth stabilised in China in Q2. Recessionary conditions are gradually diminishing in Brazil and Russia, but the near-term outlook is still fragile. In India, monsoon related developments engender greater confidence about the near-term outlook for value added in agriculture. Barring the contraction in natural gas and crude oil on account of structural bottlenecks, the core sector has been resilient as of 2016-17 so far, and should support industrial activity going forward. There are some signs of green shoots in manufacturing too, with PMIs and the Reserve Bank’s industrial outlook survey indicating a pick-up in new orders, both domestic and external. High frequency indicators of service sector activity are still, however, emitting mixed signals, although a larger number of indicators are in acceleration mode in Q1 of 2016-17. Merchandise export growth moved into positive territory in June after eighteen months, with a reasonably widespread upturn. While lower crude oil prices continued to compress the POL import bill, non-oil non-gold imports continued to shrink. Successive downgrades of global growth projections by multilateral agencies and the continuing sluggishness in world trade points to further slackening of external demand going forward. The recent sharper-than-anticipated increase in food prices has pushed up the projected trajectory of inflation. CPI inflation rose to a 22-month high in June, with a sharp pick-up in momentum overwhelming favourable base effects. The rise was mainly driven by food, with vegetable and sugar inflation higher than the usual.

International financial markets did not anticipate the Brexit vote and equities plunged worldwide, currency volatility increased and investors herded into safe havens. Since then, however, equity markets have regained lost ground. Currencies, barring the pound sterling, have stabilized. While the pace of FDI inflows to India slowed in the first two months of 2016-17, net portfolio flows were stronger after the Brexit vote, notwithstanding considerable volatility characterising these flows. The level of foreign exchange reserves rose to US$365.7 billion by August 5, 2016.

Liquidity conditions eased significantly during June and July on the back of increased spending by the Government which more than offset the reduction in market liquidity because of higher-than-usual currency demand. The injection of durable liquidity through purchases under OMOs, amounting to Rs. 805 billion so far, also helped in easing liquidity conditions, bringing the system-level ex ante liquidity deficit to close to neutrality (without seasonal adjustment). Accordingly, the average daily liquidity operation switched from net injection of liquidity of Rs. 370 billion in June to net absorption of Rs. 141 billion in July and Rs. 405 billion in August (up to August 8). The Reserve Bank conducted variable rate repos and reverse repos of varying tenors in order to manage evolving liquidity conditions, with a more active use of reverse repos to manage the surplus liquidity. Reflecting the easy liquidity conditions, the weighted average call rate (WACR) and money market weighted average rate remained on average 15 basis points below the policy repo rate since June.

Policy Stance and Rationale

• A normal monsoon and the 7th Pay Commission award likely to boost growth
• Implementation of GST should raise returns to investment and thus business
  sentiment and eventually investment
• Impact of direct effect of house rent allowances under the 7th CPC’s award need to be watched
• Growth forecast retained at 7.6% for the current fiscal
• Inflation target kept unchanged at 5% by March 2017 with upward bias
• Easy liquidity conditions are already prompting banks to modestly transmit past policy rate cuts through their MCLRs
• Monetary policy to remain accommodative and will continue to emphasise the adequate provision of liquidity

The refinements to the liquidity management framework effected in April 2016 were intended to smooth the supply of durable liquidity over the year using asset purchases and sales as needed, and progressively lower the average ex ante liquidity deficit in the system to a position closer to neutrality. The Reserve Bank intends to continue with this strategy, with the intention of closing the underlying liquidity deficit over time so that the system moves to a position of structural balance. 

The Global Economy in the New Year: A Round Up

At the start the of the new year, the global economic and financial market conditions deteriorated drastically, and were dominated by a series of events such as a renewed fall in oil prices, fresh turmoil in China’s financial market, a looming European banking crisis, and policy variations by some of the world’s key monetary authorities. Some of these events, which could have boosted sentiments significantly, actually failed to do so. Cheaper energy and commodity prices, which enhance consumers’ disposable income and lower companies’ input costs, are hurting energy companies’ profits and now seen as a threat to lender banks.1 The International Monetary Fund (IMF) notes that though a decline in oil prices driven by higher oil supply should have supported global demand given a higher propensity to spend in oil importers relative to oil exporters, several factors have dampened the positive impact of lower oil prices.2 Given the lack of structured fiscal consolidation policies that are consistent with growth, private investment and consumption have stagnated in many parts of the globe. Risk perceptions have also changed with the gloomy growth prospects. The US Federal Reserve (Fed) decided to raise its key policy rate in mid-December, in what was considered to be a watershed moment for the global economic revival. However, the consequent intensification of capital flow reversal and rise in the US dollar is deepening problems of several emerging market economies (EMEs) that were already slowing at this juncture. On the other hand, the monetary authorities in Europe and recently in Japan have taken recourse to negative interest rates to avoid deflation. While the lack of monetary policy action at this juncture could further slow domestic demand, lower interest rates have begun to hurt global financial market sentiments. Banks in Europe are under pressure to clean up their balance sheets ridden with non-performing loans since the 2007-08 crisis, and policy induced negative interest rates are hurting banks’ profitability and asset quality, as demand has failed to pick up commensurately. Financial instability risks have again come to the fore with banking sector and emerging market vulnerabilities rising, and have led to sudden strong market reactions as seen by the declines in equity and bond prices worldwide at the start of 2016.

The global economic outlook has been made worse by productivity slowdown, policy gridlock, a widening geopolitical rift and increasing leverage in EMEs with tighter liquidity conditions. Downside risks have intensified again amid heightened uncertainty about EME growth prospects, further fallouts of China’s rebalancing, volatility in financial and commodity markets, and a rise in geopolitical tensions. Projections for global growth have been revised even lower in 2016.3 The severe financial market turbulence in the first six weeks of 2016, intensified by the fears about a sharper and prolonged slowdown in the world economy, has led to calls for changes in the policy environment from different quarters. Moody's Investors Service has warned that investors may start to price in the possibility of lower economic growth and returns, which could become partly self-fulfilling via negative wealth effects and tighter financing conditions. The impact on the global economy would be amplified if losses on trading portfolios and financial assets more generally led banks to tighten credit standards. The OECD points out that sole reliance on monetary policy has proven insufficient to boost demand and produce satisfactory growth, while fiscal policy is contractionary in several major economies and structural reform momentum has slowed. An increasing number of economic analysts are now calling for a stronger fiscal policy response, as a commitment to raising public investment would boost demand and help support future growth. The OECD has noted that with governments in many countries currently able to borrow for long periods at very low interest rates, there is room for fiscal expansion to strengthen demand in a manner consistent with fiscal sustainability.
1
The price of oil, which was trending lower in the last few months of 2015, dropped below US$30 a barrel in January; the markets are oversupplied at a time when demand is faltering because of the slowdown in key importers such as China, as well as exploration of alternate energy sources in some countries.
2
Fiscal strain in many oil exporters has reduced their ability to smooth the shock, leading to a sizable reduction in their domestic demand. The oil price decline has had a notable impact on investment and employment in oil and gas extraction, also subtracting from global aggregate demand. Finally, the pickup in consumption in oil importers has so far been somewhat weaker than evidenced from past episodes of oil price declines. The impact of the fall in commodity prices has not only hit oil producers in emerging economies but also US shale producers, with firms borrowing heavily from both banks and markets against oil reserves and projected revenue.
3
The IMF in January had already lowered its earlier projections for 2016, for global and US growth by 0.2 per cent to 3.4 and 2.6 per cent, respectively, for emerging Asia by 0.1 per cent to 6.3 per cent, and for Latin America by 1.1 per cent to -0.3 per cent as Brazil’s outlook was lowered by a sharp 2.5 per cent to -3.5 per cent. The IMF forecasts the Russian economy will shrink 1 per cent this year, after contracting 3.7 per cent in 2015. The Organisation for Economic Co-operation and Development (OECD) has in February lowered forecasts for 2016 global growth further, as well as for individual economies, with the largest impacts expected in the US, the euro area and major economies reliant on commodity exports, like Brazil. Growth in the US is expected to decelerate to 2 per cent in 2016 from 2.5 per cent last year, with the dollar’s strength weighing on exports and manufacturing activity and lower oil prices curtailing investment in mining and related industries. The euro area is projected to grow at 1.4 per cent, with German growth at 1.3 per cent, both lower than 1.5 per cent in 2015. While China is expected to continue to grow at 6.5 per cent, India is expected record a robust grow of 7.4 per cent. Brazil’s economy, which is experiencing a deep recession, is expected to shrink by 4 per cent this year.

Union Budget 2016-17: Striking the Right Chords

The government’s Union Budget for the fiscal 2016-17 has a number of announcements, which could, if implemented effectively, augment the real and financial sectors of the economy. Stability has been maintained in tax rates and structures, with some benefits to smaller individual and corporate tax payers, and an orientation towards domestic manufacturing, as well as rationalisation and simplification. The budget with a much needed emphasis on the agricultural and social sectors is a step forward in addressing some of the supply-side issues in agriculture and in skilled manpower,1 at the same time this would also help in demand generation from the rural sector and weaker sections of the economy. A consolidated set of proposals for the housing sector should help the sector clear some inventory and augment demand for downstream sectors. The infrastructure sector not only has a high allocation but also high priority accorded to public-private partnerships, including introduction of a bill for dispute resolution, renegotiation of concession agreements, and a new credit rating system which gives emphasis to various in-built credit enhancement structures aimed at alleviating problems of mispriced loans. Financial sector reforms proposed earlier have been taken forward in the budget and are mostly aimed at broadening the product and investor base, as well as providing transparency, dispute resolution and exit routes. The scope of foreign investment has been further broadened,2 while retail participation in government securities market, deepening of the corporate debt market and introducing more products in the commodity derivatives market has been envisaged. A specialised resolution mechanism to deal with bankruptcy situations in banks, insurance companies and financial sector entities has been proposed. Various steps announced for stressed assets and strengthening asset reconstruction companies (ARCs), which includes permissions for 100 per cent FDI and sponsor ownership on ARCs, would also help to unclog investment bottlenecks. The fiscal deficit target is being adhered to; this lends credibility to country’s fiscal consolidation efforts and improves the prospects for better sovereign ratings. This would help capital flows and the depreciating currency, and also allow for more expansionary monetary policy to counter sluggishness in private sector demand. [More...] [For a Summary of Measures see Sample issue of EUpDates below...]

1

This includes proposals for irrigation, electrification, e-marketing of produce along with amendments to the Agricultural Produce Market Committee (APMC) Acts, agricultural credit and interest subvention, crop insurance, increased warehousing facilities amongst others. There are also measures for affordable healthcare and health insurance, skill, education and entrepreneurship development and job creation.

2

FDI to be allowed in insurance and pension sectors up to 49 per cent under the automatic route, 100 per cent in ARCs under the automatic route and 100 per cent through the FIPB route in marketing of food products produced and manufactured in India. FPIs are allowed to invest up to 100 per cent of each tranche in securities receipts issued by ARCs subject to sectoral caps. Investment limit for foreign entities on Indian stock exchanges is to be enhanced from 5 to 15 per cent on par with domestic institutions. Limit for investment by FPIs in central public sector enterprises (other than banks) listed in stock exchanges to be increased to 49 per cent from 24 per cent. Basket of eligible FDI instruments is to be expanded to include hybrid instruments subject to certain conditions.