RBI’s fifth bi-monthly monetary policy statement, 2016-17

Policy Measures

• Repo rate unchanged at 6.25%, consequently, the Reverse repo rate remains at 5.75% and the MSF rate at 6.75%. All the six members of the RBI panel voted in favour of status quo in policy.
• Cash reserve ratio or CRR unchanged at 4%. RBI withdraws the temporary 100% hike in the CRR in the fortnight beginning 10 December.
• Foreign exchange reserve rose to all-time high of $364 billion on December 2.
• RBI injected  liquidity worth Rs. 1 trillion through OMO purchases this fiscal.

 Assessment

Global growth picked up modestly in the second half of 2016, after weakening in the first half. Activity in AEs improved, led by a rebound in the US. In the EMEs, growth has moderated, but policy stimulus in China and some easing of stress in the larger commodity exporters shored up momentum. World trade is beginning to emerge out of a trough that bottomed out in July-August and shows signs of stabilising. Inflation has ticked up in some AEs, though well below target, and is easing in several EMEs. Expectations of reflationary fiscal policies in the US, Japan and China, and the waning of downward pressures on EMEs in recession are tempered by still-prevalent political risks in the euro area and the UK, emerging geo-political risks and the spectre of financial market volatility.

International financial markets were strongly impacted by the result of the US presidential election and incoming data that raised the probability of the Federal Reserve tightening monetary policy. As bouts of volatility fuelled a risk-off surge into US equities and out of fixed income markets, a risk-on stampede pulled out capital flows from EMEs, plunging their currencies and equity markets to recent lows even as bond yields hardened in tandem with US yields. The surge of the US dollar from late October intensified after the election results and triggered sizable depreciations in currencies around the world. Commodity prices firmed up across the board from mid-November on an improvement in the outlook for demand following the US election results, barring gold which lost its safe haven glitter to the ascendant US dollar. Crude prices have firmed after the OPEC’s decision to cut output.

GVA in Q2 of 2016-17 turned out to be lower than projected on account of a deeper than expected slowdown in industrial activity. Manufacturing slowed down both sequentially and on an annual basis, with weak demand conditions and the firming up of input costs dragging down the profitability of corporations. Gross fixed capital formation contracted for the third consecutive quarter. Although government final consumption expenditure slowed sequentially, it supported private final consumption expenditure, the mainstay of aggregate demand. The contribution of net exports to aggregate demand remained positive, but on account of a sharper contraction in imports relative to exports. CPI eased more than expected for the third consecutive month in October, driven down by a sharper than anticipated deflation in the prices of vegetables. Underlying this softer reading, however, was an upturn in momentum as prices rose month-on-month across the board.

Liquidity conditions have undergone large shifts in Q3 so far. Surplus conditions in October and early November were overwhelmed by the impact of the withdrawal of notes from November 9. Currency in circulation plunged by ₹7.4 trillion up to December 2; consequently, net of replacements, deposits surged into the banking system, leading to a massive increase in its excess reserves. The RBI scaled up its liquidity operations through variable rate reverse repo auctions of a wide range of tenors from overnight to 91 days, absorbing liquidity (net) of ₹5.2 trillion. From the fortnight beginning November 26, an incremental CRR of 100 per cent was applied on the increase in net demand and time liabilities (NDTL) between September 16, 2016 and November 11, 2016 as a temporary measure to drain excess liquidity from the system. Liquidity management was bolstered by an increase in the limit on securities under the market stabilisation scheme (MSS) from ₹0.3 trillion to ₹6 trillion on November 29. 

Outlook

Growth forecast cut to 7.1%, from 7.6% for this fiscal. Downside risks in the near term could travel through two major channels: (a) short-run disruptions in economic activity in cash-intensive sectors such as retail trade, hotels & restaurants and transportation, and in the unorganised sector; (b) aggregate demand compression associated with adverse wealth effects.

Inflation target remains 5% for March 2017. Demonetisation to lower prices of perishables, could reduce inflation by 10-15 basis points by December; however, crude price volatility, surge in financial market turbulence could put March-end inflation target at risk.

The decision of the MPC is consistent with an accommodative stance of monetary policy in consonance with the objective of achieving consumer price index (CPI) inflation at 5 per cent by Q4 of 2016-17 and the medium-term target of 4 per cent within a band of +/- 2 per cent, while supporting growth. The RBI’s cautious approach comes amidst a volatile global environment, which saw the rupee sink to a record low last month as part of a sell-off in emerging market assets. Pressure on the RBI to act has grown since November 8 when a drastic plan to abolish Rs 500 and Rs 1,000 notes was put in place, removing 86 percent of the currency in circulation in a bid to crack down on black money.