Transitory And Transient: How The RBI Sees The First Round Impact Of Demonetisation

The Reserve Bank of India’s decision to keep rates unchanged came against the backdrop of the government’s decision to withdraw Rs 500 and Rs 1000 notes. While many analysts had expected the demonetisation to seal the case for a 25 basis point rate cut, the RBI chose to remain in wait and watch mode. The central expects the scrapping of nearly 86 percent of the country’s currency by to have a near term impact on growth and inflation but is still to formalize its view on the medium term impact.

According to data provided by the RBI on Wednesday, Rs 11.5 lakh crore in scrapped currency has come back to the system compared to the near Rs 15 lakh crore taken out. Since the withdrawal of notes was announced, the RBI has supplied Rs 3.81 lakh crore in currency of various denominations to the banking sector. The regulator declined to say how soon the remonetisation process would be completed.

Growth Impact Of Demonetisation ‘Clouded’

The bank lowered the gross added (GVA) growth estimate for the financial year 2016-17 to 7.1 percent from 7.6 percent earlier but added that part of this cut in growth estimates is due to the weaker than expected growth in the second quarter. The Indian economy grew at 7.1 percent in the first quarter of the current fiscal and 7.3 percent in the second quarter.

The withdrawal of notes of Rs 500 and Rs 1000 could “transiently” interrupt industrial activity in the third quarter, said the MPC in its resolution. In the services sector, the outlook is mixed with construction, trade, transport, hotels and communication impacted by the temporary impact of withdrawal of Rs 500 and Rs 1000 notes.

The MPC, however, added that a “fuller” assessment of the economic impact is awaited.

According to the RBI, downside risks in the near term could travel through two major channels:

• Short-run disruptions in economic activity in cash-intensive sectors such as retail trade, hotels & restaurants and transportation, and in the unorganised sector
• Aggregate demand compression associated with adverse wealth effects

Read: RBI Keeps Repo Rate Unchanged At 6.25%; Withdraws Incremental CRR Requirement

‘Temporary Reduction’ In Inflation

The bank projected consumer price inflation at 5 percent in the fourth quarter of financial year 2016-17 with risks tilted to the upside but lower than that projected in the October review. The withdrawal of currency notes could result in a possible “temporary reduction” in inflation to the tune of 10-15 basis points in the third quarter, the RBI said.

Read: Bonds Slump in India as Policy Makers Unexpectedly Hold Key Rate

In particular, the shortage of currency has impacted the price of perishables.

“Despite some supply disruptions, the abrupt compression of demand in November due to the withdrawal of SBNs could push down the prices of perishables in the reading that becomes available in December,” the RBI said.

The underlying risks to inflation, however, remain. This prompted the central bank to keep its inflation projection for March 2017 unchanged. Volatility in crude prices and financial market turbulence could put the inflation target at “some risk”, the RBI said.

Surplus Liquidity ‘Transitory’

The surge in deposits into the banking sector had led to surplus liquidity conditions. The RBI intends to manage this through a mix of liquidity adjustment facility (LAF) operations and through the issue of market stabilization scheme (MSS) bonds. With the MSS limit now hiked to Rs 6 lakh crore, the RBI has withdrawn the 100 percent cash reserve ratio imposed on deposits between September 16 and November 11.

The RBI clearly communicated to the market that it does not intend to allow a large surplus in liquidity to persist.

The larger message from the RBI appears to be one of caution with the central bank preferring to watch incoming data before it takes a call on the economic impact of demonetisation.