Highlights of RBI’s First Bi-monthly Monetary Policy Statement, 2017-18

Policy Measures

• The Monetary Policy Committee (MPC) decided to keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.25%.
• With a view to ensuring finer alignment of the weighted average call rate (WACR), the operating target of monetary policy, with the repo rate it has been decided to further narrow the policy rate corridor around the policy repo rate to +/-25bps from +/- 50bps with immediate effect. Consequently, the reverse repo rate under the LAF is at 6.0%, and the marginal standing facility (MSF) rate and the Bank Rate are at 6.50%.
• The decision of the MPC is consistent with a neutral stance of monetary policy in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2%, while supporting growth. 

 Assessment

Indicators of global growth suggest signs of stronger activity in most AEs and easing of recessionary conditions in commodity exporting large emerging market economies (EMEs). For EMEs, the outlook is gradually improving, with indications that the slowdown characterising 2016 could be bottoming out. Inflation is edging up in AEs to or above target levels on the back of slowly diminishing slack, tighter labour markets and rising commodity prices. Among EMEs, there is a generalised softening of inflation pressures. 

International financial markets have been impacted by policy announcements in major AEs, geo-political events and country-specific factors. Equity markets in AEs were driven up by reflation trade, stronger incoming data and currency movements. Equity markets in EMEs had a mixed performance, reflecting domestic factors amidst a cautious return of investor appetite and capital flows.

The CSO released its second advance estimates for 2016-17 on February 28, placing India’s real GVA growth at 6.7% for the year, down from 7% in the first advance estimates released on January 6. Agriculture expanded robustly; in the industrial sector, there was a significant loss of momentum across all categories, barring electricity generation; and the services sector also slowed, pulled down by most categories of services.

Several indicators are pointing to a modest improvement in the macroeconomic outlook. Foodgrains production has touched an all-time high. Industrial output, measured by the index of industrial production (IIP), recovered in January from a contraction in the previous month, helped by a broad-based turnaround in manufacturing as well as mining and quarrying. The manufacturing purchasing managers’ index (PMI) remained in expansion mode in February and rose to a five month high in March on the back of growth of new orders and output. The 77th round of the Reserve Bank’s industrial outlook survey indicates that overall business sentiment is expected to improve in Q1 of 2017-18 on the back of a sharp pick up in both domestic and external demand. Coincident indicators such as exports and non-oil non-gold imports are indicative of a brighter outlook for industry, although the sizable under-utilisation of capacity in several industries could operate as a drag on investment.

 After moderating continuously over the last six months to a historic low, retail inflation measured by year-on-year changes in the CPI turned up in February to 3.7%. While food prices bottomed out at the preceding month’s level, base effects pushed up inflation in this category. Fuel inflation increased as the continuous hardening of international prices lifted domestic prices of petroleum. Kerosene prices have also been increasing since July with the programmed reduction of the subsidy. Both three months ahead and a year ahead households’ inflation expectations, reversed in the latest round of the Reserve Bank’s survey. The 77th round of the Reserve Bank’s industrial outlook survey indicates that pricing power is returning to corporates as profit margins get squeezed by input costs. Excluding food and fuel, inflation moderated in February by 20 basis points to 4.8%, essentially on transient and specific factors in items like clothing and gold.

With progressive remonetisation, the surplus liquidity in the banking system declined from a peak of Rs.7,956 billion on January 4, 2017 to an average of Rs. 6,014 billion in February and further down to Rs. 4,806 billion in March. Currency in circulation expanded during this period. Its impact on the liquidity overhang was, however, partly offset by a significant decline in cash balances of the Government up to mid-March which released liquidity into the system. Thereafter, the build-up of Government cash balances on account of advance tax payments and balance sheet adjustment by banks reduced surplus liquidity to Rs. 3,141 billion by end-March. Issuances of cash management bills (CMBs) under the MSS ceased in mid-January and existing issues matured, with the consequent release of liquidity being absorbed primarily through variable rate reverse repo auctions of varying tenors. Accordingly, the average net absorption by the Reserve Bank increased from Rs. 2,002 billion in January to Rs. 4,483 billion in March. The weighted average call money rate (WACR) remained within the LAF corridor. The maturing of CMBs and reduced issuance of Treasury bills leading up to end-March has also contributed to Treasury bill rates being substantially below the policy rate.

Merchandise exports rose strongly in February 2017 from a subdued profile in the preceding months. Growth impulses were broad-based.  The surge in imports in January and February 2017 largely reflected the effect of the hardening of commodity prices such as crude oil and coal. With imports outpacing exports, the trade deficit widened in January and February from its level a year ago, though it was lower on a cumulative basis for the period April-February 2016-17. Balance of payments data for Q3 indicate that the current account deficit for the first three quarters of the financial year narrowed to 0.7% of GDP, half of its level a year ago. For the year as a whole, the current account deficit is likely to remain muted at less than 1% of GDP.

Foreign direct investment (FDI) has dominated net capital inflows during April-December, with manufacturing, communication and financial services being the preferred sectors. FPI flows turned positive in February and welled up into a surge in March, especially in debt markets. This reversal appears to have been driven by stable domestic inflation, better than expected domestic growth, encouraging corporate earnings, clarity on FPI taxation, pro-reform budget proposals and state election results. The level of foreign exchange reserves was US$369.9 billion on March 31, 2017.

Outlook

GVA growth is projected to strengthen to 7.4% in 2017-18 from 6.7% in 2016-17, with risks evenly balanced. The pace of remonetisation will continue to trigger a rebound in discretionary consumer spending. Significant improvement in transmission of past policy rate reductions into banks’ lending rates post demonetisation should help encourage both consumption and investment demand of healthy corporations. Various proposals in the Union Budget should stimulate capital expenditure, rural demand, and social and physical infrastructure all of which would invigorate economic activity. The imminent materialisation of structural reforms in the form of the roll-out of the GST, the institution of the Insolvency and Bankruptcy Code, and the abolition of the Foreign Investment Promotion Board will boost investor confidence and bring in efficiency gains. The upsurge in IPOs in the primary capital market augurs well for investment and growth. External demand should support domestic growth. Downside risks to the projected growth path stem from the outturn of the south west monsoon; ebbing consumer optimism on the outlook for income, the general economic situation and employment as polled in the March 2017 round of the Reserve Bank’s consumer confidence survey; and, commodity prices, other than crude, hardening further.

Headline CPI inflation is set to undershoot the target of 5.0% for Q4 of 2016-17 in view of the sub-4% readings for 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. Aggregate demand pressures could build up, with implications for the inflation trajectory.

Developmental and Regulatory Policies

The RBI also sets out new measures for further refining the liquidity management framework (Management of Surplus Liquidity, Narrowing of the Monetary Policy Rate Corridor, Substitution of Collateral under the LAF Term Repos); strengthening the banking regulation and supervision (Revised Prompt Corrective Action (PCA) Framework for Banks, Raising the Minimum Level of Net Owned Funds for ARCs, Partial Credit Enhancement, Banking Outlets in underserved areas, banks’ participation in Real Estate Investment Trust (REITS) and Infrastructure Investment Trusts, Countercyclical Capital Buffer); broadening and deepening financial markets (Draft Guidelines on Simplified Hedging Facility for Forex Exposure, Introduction of Tri-party Repo, Introduction of Additional Settlement Batches for NEFT, Merchant Discount Rate rationalization, Issuance and Operation of Pre-paid Payment Instruments); and extending the reach of financial services by enhancing the efficacy of the payment and settlement systems (Pilot Project on Financial Literacy).