Highlights of RBI’s Third Bi-monthly Monetary Policy Statement, 2018-19

Following are the Highlights of RBI’s Third Bi-monthly Monetary Policy Statement,     2018-19:

Policy Measures

• The Monetary Policy Committee (MPC) decided to increase the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis points to 6.50%.
• Consequently, the reverse repo rate under the LAF stands adjusted to 6.25%, and the marginal standing facility (MSF) rate and the Bank Rate to 6.75%.
• 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

Global economic activity has continued to maintain steam; however, global growth has become uneven and risks to the outlook have increased with rising trade tensions. Among AEs, the US economy rebounded strongly in Q2, after modest growth in Q1, on the back of rising personal consumption expenditures and exports. In the Euro Area, weak growth in Q1 continued in Q2 due to subdued consumer demand, weighed down by political uncertainty and a strong currency. In Japan, recent data on retail sales, consumer confidence and business sentiment point to moderation in growth. Economic activity in major EMEs has slowed somewhat on volatile and elevated oil prices, mounting trade tensions and tightening of financial conditions. The Chinese economy lost some pace in Q2, pulled down by efforts to contain debt. The Russian economy picked up in Q1; recent data on employment, industrial production and exports indicate that the economy has gained further momentum. South Africa’s economy contracted in Q1; though consumer sentiment has improved, high unemployment and weak exports pose challenges. In Brazil, economic activity suffered a setback in Q1 on nation-wide strikes; more recent data suggest that growth remained muted as industrial production contracted in May and the manufacturing PMI declined.

Global trade lost some traction due to intensification of trade wars and uncertainty stemming from Brexit negotiations. Crude oil prices, which remained volatile and elevated in May-June on a delicate demand-supply balance, eased modestly in the second half of July on higher supply from OPEC and non-OPEC producers. Base metal prices have fallen on the general risk-off sentiment triggered by fears of an intensification of trade wars. Gold prices have softened on a stronger dollar. Inflation remained firm in the US, reflecting higher oil prices and stronger aggregate demand. Inflation has edged up also in some other major advanced and emerging economies, driven, in part, by rising energy prices and pass-through effects from currency depreciations.

Global financial markets have continued to be driven mainly by monetary policy stances in major AEs and geopolitical tensions. Equity markets in AEs have declined on trade tensions and uncertainty relating to Brexit negotiations. Investors’ appetite for EME assets has waned on increases in interest rates by the US Fed. The 10-year sovereign yield in the US has moderated somewhat from its peak on May 17 on safe-haven demand, spurred by escalating trade conflicts. Yields have softened in other key AEs as well. In most EMEs, however, movements in yields have varied reflecting domestic macroeconomic fundamentals and tightening global liquidity. Capital flows to EMEs declined in anticipation of monetary policy tightening in AEs. In currency markets, the US dollar appreciated, supported by strong economic data. The euro strengthened in June on receding political uncertainty and taper talk by the central bank. However, the currency has traded soft thereafter on mixed economic data and the rising US dollar. EME currencies, in general, have depreciated against the US dollar over the last month.

In India IIP strengthened in April-May 2018 on a y-o-y basis. This was driven mainly by a significant turnaround in the production of capital goods and consumer durables. Growth in the infrastructure/construction sector accelerated sharply, reflecting the government’s thrust on national highways and rural housing, while the growth of consumer non-durables decelerated significantly. The output of eight core industries accelerated in June due to higher production in petroleum refinery products, steel, coal and cement. Capacity utilisation in the manufacturing sector remains robust. The assessment based on the Reserve Bank’s business expectations index (BEI) for Q1:2018-19 remained optimistic notwithstanding some softening in production, order books and exports. The July manufacturing PMI remained in expansion zone, although it eased from its level a month ago with slower growth in output, new orders and employment.

 Retail inflation, measured by year-on-year change in the CPI rose from 4.9 per cent in May to 5 per cent in June, driven by an uptick in inflation in fuel and in items other than food and fuel even as food inflation remained muted due to lower than usual seasonal uptick in prices of fruits and vegetables in summer months. Low inflation continued in cereals, meat, milk, oil, spices and non-alcoholic beverages, and pulses and sugar prices remained in deflation. Fuel and light group inflation rose sharply, pulled up by LPG and kerosene, while electricity inflation remained low. The pass-through of global crude oil prices impacted inflation in domestic petroleum products as well as transport services. Inflation also picked up modestly in respect of education and health. The June round of the Reserve Bank’s survey of households reported a further uptick of 20 basis points in inflation expectations for both three-month and one-year ahead horizons as compared with the last round. Manufacturing firms polled in the Reserve Bank’s industrial outlook survey reported higher input costs and selling prices in Q1:2018-19. The manufacturing PMI showed that input prices eased slightly in July, although they remained high. Input costs for companies polled in Services PMI in June also stayed elevated. Farm and non-farm input costs rose significantly. Notwithstanding some pick-up in February and March 2018, rural wage growth remained moderate, while wage growth in the organised sector remained firm.

The liquidity in the system remained generally in surplus mode during June-July 2018. In June, the Reserve Bank absorbed surplus liquidity of around Rs.140 billion on a daily net average basis under the LAF even as the system migrated from net surplus to a net deficit mode in the second half of the month due to advance tax outflows. Interest rates in the overnight call money market firmed up in June reflecting the increase in the repo rate on June 6, 2018. The weighted average call rate (WACR) traded, on an average, 12 basis points below the repo rate – the same as in May. Systemic liquidity moved back into surplus mode in early July with increased government spending but turned into deficit from July 10 onwards; on a daily net average basis, the Reserve Bank injected liquidity under the LAF of Rs.107 billion in July. The WACR in July, on an average, traded 9 basis points below the policy rate. Based on an assessment of prevailing liquidity conditions and of durable liquidity needs going forward, the Reserve Bank conducted two open OMO purchase auctions of Rs.100 billion each on June 21 and July 19, 2018.

Merchandise exports growth picked up in May and June 2018 on a y-o-y basis, aided by engineering goods, petroleum products, drugs and pharmaceuticals, and chemicals. During the same period, merchandise import growth also accelerated largely due to an increase in crude oil prices. Among non-oil imports, gold imports declined due to lower volume, while imports of machinery, coal, electronic goods, chemicals, and iron and steel increased sharply. Double-digit import growth in May and June pushed up the trade deficit. While net FDI inflows improved significantly in the first two months of 2018-19, with the tightening of liquidity conditions in AEs, growing geopolitical concerns and with the escalation of protectionist sentiment, net FPI outflows from the domestic capital market have continued, albeit at an increasingly slower rate. India’s foreign exchange reserves were at US$404.2 billion on July 27, 2018.

Outlook

 GDP growth outlook for 2018-19 is retained at 7.4 per cent as in the April policy. GDP growth is projected in the range of 7.5-7.6 per cent in H1 and 7.3-7.4 per cent in H2, with risks evenly balanced. Various indicators suggest that economic activity has continued to be strong. The progress of the monsoon so far and a sharper than the usual increase in MSPs of kharif crops are expected to boost rural demand by raising farmers’ income. Robust corporate earnings, especially of fast moving consumer goods (FMCG) companies, also reflect buoyant rural demand. Investment activity remains firm even as there has been some tightening of financing conditions in the recent period. Increased FDI flows in recent months and continued buoyant domestic capital market conditions bode well for investment activity. The Reserve Bank’s IOS indicates that activity in the manufacturing sector is expected to remain robust in Q2, though there may be some moderation in pace. Rising trade tensions may, however, have an adverse impact on India’s exports.

Headline inflation outlook is driven primarily by several factors. First, the central government has decided to fix the MSPs of at least 150 per cent of the cost of production for all kharif crops for the sowing season of 2018-19. This increase in MSPs, which is much larger than the average increase seen in the past few years, will have a direct impact on food inflation and second round effects on headline inflation. A part of the increase in MSPs based on historical trends was already included in the June baseline projections. However, there is a considerable uncertainty and the exact impact would depend on the nature and scale of the government’s procurement operations. Second, the overall performance of the monsoon so far augurs well for food inflation in the medium-term. Third, crude oil prices have moderated slightly, but remain at elevated levels. Fourth, the central government has reduced GST rates on several goods and services. This will have some direct moderating impact on inflation, provided there is a pass-through of reduced GST rates to retail consumers. Fifth, inflation in items excluding food and fuel has been broad-based and has risen significantly in recent months, reflecting greater pass-through of rising input costs and improving demand conditions. Finally, financial markets continue to be volatile. Based on an assessment of the above-mentioned factors, inflation is projected at 4.6 per cent in Q2 and 4.8 per cent in H2 of 2018-19, with risks evenly balanced. Excluding the HRA impact, CPI inflation is projected at 4.4 per cent in Q2 and 4.7-4.8 per cent in H2.

Developmental and Regulatory Policies

• Extension of MSF to Scheduled Primary (Urban) Cooperative Banks, and extension of LAF and MSF to Scheduled State Cooperative Banks, complying with the eligibility criteria prescribed for LAF / MSF, as part of the Reserve Bank’s continuous efforts in improving the transmission of monetary policy to money market rates.
• Investment in Non-SLR Securities by Primary (Urban) Cooperative Banks. In order to bring further efficiency in price discovery mechanism and as a step towards harmonization of regulations they will be permitted to undertake eligible transactions for acquisition / sale of non-SLR investment in secondary market with mutual funds, pension / provident funds, and insurance companies. This is in addition to undertaking eligible transactions with Scheduled Commercial Banks and Primary Dealers.    
• Co-origination of loans by Banks and Non-Banking Financial Companies (NBFCs) for lending to the priority sector to provide the much-needed competitive edge for credit to the priority sector. All SCBs (excluding Regional Rural Banks and Small Finance Banks) may co-originate loans with NBFCs - NBFC-ND-SIs, for the creation of eligible priority sector assets. The co-origination arrangement should entail joint contribution of credit by both lenders at the facility level. It should also involve sharing of risks and rewards between the banks and the NBFCs for ensuring appropriate alignment of respective business objectives, as per their mutual agreement.

Financial Markets

• Review of Foreign Exchange Derivative facilities for Residents (Regulation FEMA-25):  It is now proposed to undertake a comprehensive review of FEMA 25, in consultation with the Government of India, to, inter alia, reduce the administrative requirements for undertaking derivative transactions, allow dynamic hedging, and allow Indian multinationals to hedge the currency risks of their global subsidiaries from India.
• Comprehensive Review of Market Timings: It is necessary that timings across products and funding markets complement each other and avoid unanticipated frictions. It is, therefore, proposed, to set up an internal group to comprehensively review timings of various markets and the necessary payment infrastructure for supporting the recommended revisions to market timings. 
• Review of SGL/ CSGL Guidelines: In order to facilitate greater participation in the G-Secs markets and to provide market participants further operational ease in opening and operating of Subsidiary General Ledger (SGL) and Constituent Subsidiary General Ledger (CSGL) Accounts, it has been decided to review comprehensively the SGL/CSGL Guidelines.