RBI's rate cut, along with the recent reduction in small savings rates and the move towards a marginal cost-based lending rate mechanism, are likely to fast track monetary policy transmission, says Nomura in a report
The Reserve Bank of India (RBI), in its first bi-monthly credit policy review for FY2016-17 has cut repo rate by 25 basis points (bp) to 6.50%. The central bank also decided to narrow the policy rate corridor to 50bp from 100bp by reducing the marginal standing facility (MSF) rate by 75bp and increasing reverse repo rate by 25bp. While the RBI has left the door open to more easing, it will keep the rates on hold and instead its focus will remain towards enabling better transmission, says a research report.
In the note, Nomura, says, "Even as the RBI cut the repo rate by only 25bp, the effective reduction is larger. So far, tight banking system liquidity has meant that the weighted average call money rate is fixed at around 15bp above the repo rate. However, in the policy announcement, the RBI has committed to multiple liquidity measures, which will ensure that the weighted average call rate fixes close to the repo rate, ensuring a larger ‘effective’ reduction in the overnight call rate than just 25bp."
"Since April 2014, while the RBI has cut the policy rate cumulatively by 125bp, the average base rate of major banks has fallen by only about 70bp. The RBI’s plans to move the system from a liquidity deficit to neutral gradually, the savings rate deregulation by the government (March 2016) and a move to marginal cost-based pricing, should all allow banks to lower their lending rates over time," the report says.
In its forward guidance, the RBI stated, “the stance of monetary policy will remain accommodative. The Reserve Bank will continue to watch macroeconomic and financial developments in the months ahead with a view to responding with further policy action as space opens up.”
In the post policy call with analysts, RBI governor Dr Raghuram Rajan had stated that the RBI is “open to looking for more room (for easing) while recognising that there could be risks to inflation on both sides.” However, he clarified that going forward, the “pace of transmission is the focus”, and will be helped by the move to the marginal cost-based pricing of loans.
According to Nomura, the key focus for RBI's policy meeting this time was fast-tracking policy transmission via ensuring adequate liquidity provision. In this regard, the Reserve Bank announced, moving banking liquidity from a deficit to neutral; narrowing the corridor from 100bp to 50bp and a reduction in the minimum daily CRR balance. Overall, these measures should provide more comfort to banks on liquidity and enable faster transmission, the report added.
The RBI has committed to moving banking system liquidity from a deficit of 1% of net demand and time liabilities (NDTL) to a position close to neutrality over a period of one-to-two years. Nomura says, this would mean a large liquidity injection on two counts, the need for the RBI to expand its balance sheet in line with the annual reserve money requirement via US dollar purchases and or open market operations. The RBI estimates this at Rs150-Rs200 billion per month. Secondly additional liquidity to move the banking system deficit gradually towards neutral. Assuming a deficit of 1% of NDTL and a gradual reduction of Rs100 billion per month, it would take eight months to move from a negative to a neutral liquidity stance.
The RBI also lowered the marginal standing facility rate by 75bp to 7% and raised the reverse repo rate by 25bp to 6%, thus narrowing the interest rate corridor to 50bp. The narrowing of the interest rate corridor is expected to enable the alignment of the weighted average call rate closer to the repo rate, Nomura says.
At present, banks have to maintain a cash balance of 95% of the required cash reserve ratio (CRR) (4% of the NDTL) on a daily basis. The RBI reduced this to 90% from 16 April 2016 to give banks more flexibility in managing their funds.
In addition, Nomura expects, the RBI, for its liquidity operations, to clearly distinguish between required durable liquidity, consistent with growth and money multiplier and short-term liquidity. "First, the RBI will ensure adequate provision of durable liquidity via expansion of net foreign assets (forex purchases without sterilisation) and domestic assets (OMO purchases), as needed. After meeting the requirements of durable liquidity, the RBI will use short-term liquidity operations to ensure that the call rate hugs the policy rate (now: repo rate, over time: 14 day term repo rate). For addressing short-term fluctuations, the RBI stated that it will be consulting with the government to smoothen build-up of government cash balances."
The RBI did not make any changes to its growth and inflation projections. In its baseline, the RBI projects consumer price index (CPI) inflation moderating to 5.1% by first quarter of 2017 and further to 4.2% by first quarter of 2018. It expects the implementation of the Seventh Pay Commission recommendations to add 100-150bp to its baseline projection.
"We expect the RBI to stand pat until end-2016, as we do not see inflation undershooting 5% on a sustained basis as the cyclical factors driving disinflation (oil price falls, a slowdown in rural wage growth and the large negative output gap) are behind us. Instead, we expect transmission via more liquidity injection to remain the focus," Nomura said.