ICRA expects the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) to keep the repo rate unchanged in the upcoming policy review in April 2017, given the shift in focus to bringing the CPI inflation to 4% in a durable manner, from the target of reducing it to 5% by March 2017.
ICRA does not expect the Central Bank to increase the cash reserve ratio (CRR) to absorb the continuing large surpluses in systemic liquidity, as that would constrain banks from reducing the marginal cost of funds based lending rate (MCLR).
Naresh Takkar, Managing Director and Group CEO, ICRA, said, ''Although the CPI inflation is likely to significantly undershoot the March 2017 target, we do not expect a repo rate cut in the upcoming policy review in April 2017, with the MPC firmly focused on the medium term target of 4.0%.''
''In contrast to the stated stance of maintaining systemic liquidity closer to neutral, the gradual pace of remonetisation after the note ban has led to prolonged liquidity surpluses. Nevertheless, the Central Bank is unlikely to increase the CRR to absorb the surplus liquidity, as that would discourage banks from reducing their MCLR, delaying the transmission of past monetary easing. Open market sales of the RBI’s holdings of government securities could be employed as a tool to manage liquidity at this juncture,'' Takkar added.
The year-on-year (YoY) CPI inflation rose from the series-low 3.2% in January 2017 to 3.7% in February 2017, led by the food inflation, which was entirely expected given the unwinding of the base effect. Encouragingly, the core-CPI inflation (excluding food & beverages and fuel & light) eased to 4.8% in February 2017 from 5.0% in January 2017, with even services such as health and education displaying a downtrend in inflation.
ICRA expects the CPI inflation to rise to ~4.5% in March 2017, as the favourable base continues to fade, while undershooting the RBI's projection of 5.0% for Q4 FY2017 by a wide margin. However, with greater emphasis on bringing inflation in a durable manner to 4.0%, i.e. the mid-point of the CPI inflation band of 2.0-6.0%, ICRA expects the MPC to maintain status quo on the repo rate in the April 2017 policy review.
The WPI inflation recorded a much sharper uptick to 6.5% in February 2017 from 5.2% in January 2017. Some of the factors that led to the spike in the WPI inflation are not part of the CPI basket, for instance commodities such as crude oil and coal. In ICRA’s view, the second-order transmission of the spike in the WPI inflation to the CPI inflation would be muted and significantly lagged, limiting the concerns regarding the outlook for the latter.
In February 2017, the MPC had indicated that CPI inflation would trend between 4.0-4.5% in H1 FY2018, after which it would rise to 4.5-5.0% in H2 FY2018, with risks evenly balanced around this projected trajectory. While crude oil prices have eased and the rupee has strengthened since then, there remains a lack of clarity on other inflation risks such as the monsoon dynamics and revision in allowances of Central Government employees and pensioners, particularly the house rent allowance. Therefore, a significant revision in the MPC's CPI inflation outlook for FY2018 is unlikely at this stage. However, growth forecasts for FY2017 and FY2018 may be revisited, from the February 2017 estimates of 6.9% and 7.4%, respectively.
With only around 80% of the demonetised currency likely to be replaced by end-March 2017, the surplus in systemic liquidity is expected to continue. At present, excess liquidity of over Rs. 4 trillion is entirely being absorbed under the Liquidity Adjustment facility, with the stock of Cash Management Bills issued under the Market Stabilisation Scheme during December 2016-January 2017, having matured by now.
Nevertheless, ICRA does not expect the Central Bank to increase the CRR from the current level of 4% to absorb the surplus liquidity, as that would deter banks from reducing the MCLR based lending rates, delaying the transmission of past monetary easing. In contrast, open market sales of the RBI’s holdings of Government securities that stood at Rs. 7.5 trillion on March 10, 2017, could be utilised to absorb what is turning out to be a prolonged liquidity surplus. Such sales of bonds would also help to absorb the INR liquidity generated vide any purchases of foreign exchange, simultaneously shoring up the country's forex reserves and slowing the sharp appreciation of the INR.
