Mumbai: When the monetary policy committee (MPC) of the Reserve Bank of India (RBI) held its sixth meeting on 1-2 August, a cut in borrowing costs was pretty much a no-brainer.
With consumer price inflation slowing to a record 1.54% in June on retreating food prices and factory output growth decelerating to 1.7% in May, from 3.1% in April, the case for a cut in the central bank’s key repurchase rate, the rate at which RBI infuses liquidity into the banking system, was too compelling to ignore.
The only question, to some minds, was on the size of the cut. Would the MPC prefer to err on the side of caution and cut the repurchase rate by 25 basis points, as predicted by many economists, or would it choose to be bolder and opt for a deeper cut to silence the clamour for cheaper money once and for all in the current rate cycle?
A basis point is one-hundredth of a percentage point.
In the end, the MPC decided on a 25 basis point cut to the repo rate to 6% from 6.25%—the lowest since 2010. The reverse repo rate, at which the central bank borrows money from commercial banks, was lowered to 5.75% and the marginal standing facility (MSF) rate and the bank rate to 6.25%.
Under MSF, banks borrow from the central bank by pledging government securities at a rate higher than the repo rate. Bank rate is the rate at which RBI gives loans to commercial banks without keeping any collateral.
“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,” RBI said in its monetary policy statement.
It wasn’t a unanimous decision. Four members of the MPC—RBI governor Urjit Patel and deputy governor Viral V. Acharya, besides Chetan Ghate and Pami Dua—voted for a 25 basis point reduction in the repo rate. Ravindra Dholakia, a professor at the Indian Institute of Management, Ahmedabad, wanted a 50 basis point cut. Michael Patra, executive director at RBI, wanted rates to be held steady.
Some of the upside risks to inflation such as poor monsoon rainfall and adverse impact from the roll out of the goods and services tax hadn’t materialized, the policy statement said.
“We welcome the 25 basis point cut in the repo rate as an important step necessary to converge toward the appropriate real monetary conditions for sustained growth consistent with India’s potential and for stable, moderate inflation,” said economic affairs secretary Subhash Chandra Garg.
The MPC listed a modest firming of global demand and stable commodity prices that have supported global trade, resilient international financial markets and stable emerging market currencies are other positives. “Noting, however, that the trajectory of inflation in the baseline projection is expected to rise from current lows, the MPC decided to keep the policy stance neutral and to watch incoming data. The MPC remains focused on its commitment to keeping headline inflation close to 4% on a durable basis,” the statement said.
BSE’s benchmark Sensex fell 0.3% to 32,476.74 points. Bonds declined, with the yield on Indian government notes due May 2027 rising three basis points to 6.47%, according to prices from RBI’s trading system cited by Bloomberg. Bond yields and prices move in opposite directions. The rupee rose as much as 0.6% to 63.7125 per dollar, its strongest level since July 2015.
“The RBI was hard pressed to cut given the sharp fall in inflation. I don’t think there will be further rate cuts as far as this calendar year is concerned as they are clearly reiterating the offside risk to inflation,” Reuters cited Hitesh Jain, senior research analyst at IIFL Wealth and Asset Management, as saying. “Given the prevalent inflation rate, there is room to cut, but they are clearly stating that they are not sure how the inflation trajectory will evolve in the next quarter or two.”
It was the second rate cut since Patel succeeded Raghuram Rajan as RBI governor in September 2016. After reducing the repo rate, the rate at which RBI lends overnight money to commercial banks, on 4 October, the inflation-targeting MPC left it unchanged for four meetings in a row, insisting that it could not overlook upside price risks that ranged from global factors such as potential oil price increases and US interest rate hikes to domestic ones such as an increase in house rent allowances for government staff and fallout from the 1 July switch to the new goods and services tax.
In February, RBI shifted its monetary policy stance to neutral from accommodative, ending the easy money policy that it had adopted since January 2015. During the period from January 2015 to October 2016, RBI reduced the repo rate by 175 basis points.
On hindsight, its inflation concerns proved to be overblown. The June inflation rate, as measured by the consumer price index, was 246 basis points below RBI’s medium-term target of 4%. It was also below the central bank’s April-September forecast range of 2% to 3.5%. Even core inflation, which excludes food and fuel prices that tend to be volatile, has lagged RBI’s medium-term target.
Going into its sixth meeting, pressure on the MPC, which is headed by the RBI governor and comprises three RBI representatives and three government nominees, to cut rates would have been immense.
After RBI left rates steady in June, chief economic adviser Arvind Subramanian said he disagreed with the central bank and suggested that softening inflation and slowing economic growth warranted a “substantial monetary policy easing”.
“Inflation forecast errors have been large and systematically one-sided in overstating inflation,” Subramanian said, noting that the inflation outlook had been rendered “benign by an appreciating exchange rate, a good monsoon and a capping of oil prices by structural shifts.”
Meanwhile, real gross value added (GVA), a measure of economic activity that excludes net indirect taxes from gross domestic product, slowed to a growth pace of 5.6% in the March quarter, its fourth consecutive quarterly decline. Factories are running at 73% of capacity and bank credit growth is the slowest in 15 years.
“Even personal loan growth that proxies for consumption has recently been decelerating,” said Subramanian.
To be sure, the rate cut is unlikely to immediately spur investment demand in an economy where many companies are weighed down by a mountain of bad debt, the legacy of an economic downturn that left many over-extended borrowers unable to repay bank loans. Banks are saddled with stressed assets estimated at Rs10 trillion.
And risks still loom, including the possibility of the European Central Bank tapering its €60 billion ($69 billion) a month bond-buying programme and the US Federal Reserve trimming assets acquired through its monetary easing policy, which led to an increase in the size of the Fed’s holdings from $900 billion to $4.5 trillion, as Mint consulting editor Tamal Bandyopadhyay wrote in a 31 July column.
Indian financial markets have been on a roll this year, thanks to healthy foreign portfolio investments plus record inflows into domestic mutual funds. The Sensex has risen around 22.3% and the rupee has gained over 6% so far this. Foreign investors have bought $8.9 billion and $17.51 billion in local equity and debt markets, respectively, as of Monday. Such investments may slow if policies tighten in the US and Europe.
The rate cut on Wednesday was widely seen as RBI’s last chance to stimulate growth.
“RBI’s rate cut today was well priced in by markets given the significant undershoot on inflation in the last three months—therefore, no surprises there,” said Shankar Raman, chief investment officer, third party products, Centrum Wealth Management. “The cheer however was diluted by the cautious undertone of the policy statement—with the RBI guiding inflation higher here-on which markets interpreted as ‘no room for further rate cuts’. Some sections of the market had expected a 50bp (basis point) cut today—this explains the minor pull back in bond prices post the policy. In summary, the RBI will likely stay data dependent as far as rate actions are concerned—for now, bond yields are likely to trade in a flat range and oscillate in response to inflation prints.”
RBI noted some uncertainties around the inflation trajectory.
“Implementation of farm loan waivers by States may result in possible fiscal slippages and undermine the quality of public spending, entailing inflationary spillovers,” the monetary policy statement said. “Moreover, the timing of the States’ implementation of the salary and allowances award is critical—it is not factored into the baseline projection in view of lack of information on their plans.
“If States choose to implement salary and allowance increases similar to the Centre in the current financial year, headline inflation could rise by an additional estimated 100 basis points above the baseline over 18-24 months. Also, high frequency indicators suggest that price pressures are building up in vegetables and animal proteins in the near months.”
The MPC noted an “urgent need” to reinvigorate private investment and remove infrastructure bottlenecks to boost economic growth, calling for speedier project clearances by states.
“On their part, the government and the Reserve Bank are working in close coordination to resolve large stressed corporate borrowers and recapitalise public sector banks within the fiscal deficit target. These efforts should help restart credit flows to the productive sectors as demand revives,” it said.
What the MPC has done so far
A basis point is one-hundredth of a percentage point. Here is a look what the mpc did at the last five meetings:
■ 4 October 2016: The MPC, at its first meeting, unanimously cut the repo rate, at which it infuses liquidity into the banking system, by 25 basis points to 6.25%. It was also the first policy review with Urjit Patel as governor of RBI. Minutes of the meeting, released on 18 October 2016, showed members were of the view that the risks to inflation had diminished. They also that said while there were signs of improvement in economic activity, a monetary policy boost was needed to improve investment demand.
■ 7 December 2016: Against the backdrop of the 8 November invalidation of high-value banknotes, all members adopted a more cautious approach and agreed to keep the repo rate unchanged. Members, especially those representing the RBI, said the impact of demonetisation would be transitory. The forecast for gross value added, an economic growth metric, for fiscal 2016-17 was slashed to 7.1% from 7.6%. Members noted upside risks in achieving the medium-term inflation target of CPI at 4%, and the looming threat of a rate hike in the US, which eventually took place a week later.
■ 8 February 2017: All members of the MPC decided to keep the repo rate unchanged but shifted the stance to neutral from accommodative, ending the easy money policy adopted since January 2015. Governor Patel said moving to neutral will provide sufficient room to act on rates on either side, minutes released on 22 February showed. Members noted that inflation was slowing mainly due to a fall in vegetable prices, which have strong seasonal patterns. On growth, the MPC said discretionary consumer demand, hurt by demonetisation, may bounce back. Transmission of past rate cuts by banks, because of abundant liquidity in the banking system, to lending rates can improve demand. The growth projection for fiscal 2017 was slashed to 6.9%.
■ 6 April 2017: The monetary policy hawks were all out in the first policy meeting of fiscal 2018. When the MPC met, two consecutive inflation prints, for January and February, were sub-4%, which suggested the interim target of retail inflation at 5% by March 2017 was achievable. With focus on meeting the medium-term target of 4%, MPC members noted that while headline figures were on the way down due to falling food prices, core inflation, which excludes the volatile component of food and fuel, remained sticky. Additionally, there were upside risks to inflation because of the pending implementation of the goods and service tax and an increase in housing rent allowance to government employees. All members voted to hold the repo rate, but RBI raised the reverse repo rate—at which it drains liquidity from the banking system—by 25bps to 6%. This was at a time when liquidity was plentiful because of a deluge of deposits of invalidated banknotes. In an excess liquidity situation, the reverse repo rate is the effective policy rate.
■ 7 June 2017: The MPC softened its hawkish policy rhetoric after retail inflation and economic growth slowed sharply, but left the repo rate unchanged. For the first time, the decision was not unanimous. One member, Ravindra Dholakia, a professor at the Indian Institute of Management, Ahmedabad, called for a 50bps cut. He said inflationary expectations, according to RBI’s survey of households, were unambiguously easing and were among the lowest levels observed. The MPC projected headline inflation at 2-3.5% in the first half of the year and 3.5-4.5% in the second half. It also slashed the target for gross value added by 10bps to 7.3%.