Rate Cut Likely This Week; RBI May Step In To Support Growth, Say Economists

With the the demonetisation of old currency notes likely to act as a wrench in the speeding wheel of India’s growth this year, the Reserve Bank of India is widely expected to step in and attempt to fix the situation, a poll of top economists showed.

A majority of the 13 respondents (that is, 77 percent) in a BloombergQuint poll expect the RBI to reduce the policy rate by 25 basis points to 6 percent. A basis point is one hundredth of a percentage point. Only one respondent expects the RBI to cut the repo rate by 50 basis points, while the remaining 15 percent think the central bank will maintain a status quo.

The Monetary Policy Committee, which will decide on the policy rate for the second time since its inception, will meet on Tuesday and Wednesday. The result of the deliberations of the six-member team chaired by RBI Governor Urjit Patel will be announced at the central bank’s fifth bi-monthly monetary policy review on Wednesday.

Growth Rate Worry Could Prove Decisive

The Indian economy grew at 7.3 percent in the quarter-ended September, data released by the Central Statistics Office last week showed. Prior to demonetisation, this would have been viewed as in line with the RBI’s target of 7.6 percent for the full financial year.

But the currency curb, which made around 86 percent of the cash in circulation invalid, is expected to significantly slow down India’s growth in the second half of the financial year, likely putting paid to the RBI’s growth target.

“Using the cash elasticity of GDP growth, we forecast the current quarter to grow 5 percent, and the next quarter to grow 6 percent year-on-year, on average about 2 percentage points lower than we had anticipated before demonetisation,” said HSBC in a note released on Friday.

Economic data released since the demonetisation was announced has not yet provided a clear picture of the degree of the impact on growth. The Purchasing Managers’ Index (PMI), an indicator of the health of the manufacturing sector, slowed to 52.3 in November from 54.4.

Brokerage firm Nomura in a note said, “Interestingly, the consumer goods sector, which has reported solid growth so far, was the weakest performer this month. This suggests that consumption – the sole growth driver – has been hit rather sharply.”

HSBC said the fact that the PMI slowed, but did not contract, was puzzling. “How can real activity continue to expand (albeit more slowly) when cash, that enables transactions, especially in a cash intensive country like India, is contracting?” it said.

The answer, it believes, could be credit, as a lot of transactions could have continued to take place on good faith.

The RBI’s growth forecast for the fiscal year 2016-17 will therefore be keenly watched.

Just over half of the respondents in BloombergQuint’s poll expect the RBI to revise its growth forecast for the year downward by 50-100 basis points. It currently stands at 7.6 percent.

A smaller number, 38 percent, expect the forecast to be reduced by less than 50 basis points, while only 1 respondent said it would be left unchanged.

Inflation Cools

In its last monetary policy statement, the RBI had stuck to its inflation target of 5 percent for March 2017, but had warned of upside risks to this target. Economists believe that the upside risks have now waned.

The latest data for October, shows that retail inflation, at 4.2 percent, is nearing the RBI's medium-term target of 4 percent. Inflation in October moderated from the 4.39 percent registered in September as both food and non-food prices cooled.

The RBI has committed to a medium-term target of maintaining consumer price inflation in a band of two percentage points above and below 4 percent.

Most respondents in BloombergQuint's poll said the RBI to set its inflation target for March firmly below the 5 percent mark. None expect the target to shift to close to 4 percent, while a small number said the current target will be retained.

Another Rate Cut This Fiscal?

With inflation easing, and growth likely to take a hit, economists expect that the RBI will step in again later this financial year to give the economy a further stimulus through a reduction in rates.

As many as 61 percent of respondents feel that the RBI will cut the policy rate by 50 basis points in the remainder of the financial year, including the likely policy action next week. One respondent, the one that foresees a 50 basis point cut in the policy review on Wednesday, expects the total reduction in the rest of the year to be 75 percent.

A sizable number, 31 percent, expect 25 basis points to be the total reduction in the remainder of FY17, meaning that the policy rate will be 6 percent at the end of the year.

The Liquidity Situation

The rush to deposit scrapped Rs 500 and Rs 1,000 notes after November 9 left the banking system flush with liquidity till last week. As on November 27, a total of Rs 8.45 lakh crore in the demonetised notes had been deposited with banks.

Initially, the RBI tried to mop up the excess liquidity by using term reverse repo auctions as part of its liquidity adjustment facility. Its efforts were somewhat hampered by the fact that it had only Rs 7 lakh crore in government bonds to give to banks as collateral for their deposits.

What followed was a move that sucked out around Rs 3.25 lakh crore from the banking system. Last weekend, the RBI, in a surprise move, asked banks to maintain a 100 percent cash reserve ratio (CRR) on deposits between September 16 and November 11. This, it said, would be a temporary move, and would be reviewed on December 9.

Then, on Friday, the government raised the limit for issuing market stabilisation scheme (MSS) bonds to Rs 6 lakh crore from Rs 30,000 crore earlier. On the same day, the RBI said it would auction cash management bills worth Rs 20,000 crore under the scheme.

The RBI received competitive bids worth a total of Rs 40,765 crore for the 28-day cash management bills, and accepted bids worth Rs 20,000 crore at a cut off price of Rs 99.53. The yield to maturity on these bonds therefore is 6.1557 percent.

Economists said the combination of the reverse repo and the market stabilisation scheme would cater to a large portion of the excess liquidity that will arise out of the demonetisation scheme, that is around Rs 13 lakh crore out of the Rs 14 lakh crore of old notes that were in circulation before November 9.

This means that the RBI is likely to wind down the CRR measure, though the timing of this could depend on how quickly it manages to auction the MSS bonds.

Another option available to the RBI is to raise the CRR rate, which currently stands at 4 percent of net demand and time liabilities. The cash reserve ratio is the amount of money banks park with the RBI as a contingency. No interest rate is paid on these deposits.

Most of the respondents on the poll that was conducted over the course of last week expected the RBI to use a combination of the cash reserve ratio and market stabilisation scheme.

Government, RBI Must Work In Tandem

Almost all the respondents said growth supportive measures are required to give the economy a jump start after demonetisation.

They were, however divided on which form of stimulus is required.

Nearly 38 percent of the respondents said fiscal stimulus was the need of the hour, while 54 percent suggested a mix of monetary and fiscal stimulus.

Some respondents stated that to bring the economy back on track replacing the withdrawn currency quickly is more important than a stimulus, as this would resuscitate consumption and subsequently growth.

There is still no information from the RBI as to the number of new notes that have been printed and entered circulation.