The macroeconomic environment in India has undergone a significant change since the last monetary policy review on October 4. The risks to growth have risen since, but those to inflation have declined, at least for the rest of the current fiscal. That’s a result of the demonetisation of Rs 500 and Rs 1,000 bank notes.
Given the milieu, the Reserve Bank of India (RBI) could cut the repo rate by 25 basis points during its monetary policy review on December 7.
Quantifying the impact of demonetisation on GDP is tough given its unprecedented nature and the continuously evolving scenario. The channels through which it will work on GDP are understood, but the extent of impact will depend on the duration of the cash crunch currently prevailing. The problem is compounded by the fact that the massive informal, or unorganised, sector is very cash dependent and is not accurately measured.
We believe the cash crunch will impact private consumption demand (equal to 55 percent of GDP) directly and bring down GDP growth in the third and fourth quarters of the current fiscal.
Assuming that it will take at least a few months for the situation to normalise, we have cut our GDP growth forecast to 6.9 percent for the current fiscal from 7.9 percent earlier. The economy grew at 7.3 percent in the first half of the current fiscal and growth was expected to pick up in the second half. But after demonetisation, we expect GDP growth to decline to 6.6 percent in the second half.
The RBI’s Next Move
During the October review of monetary policy, the RBI had cut the repo rate by 25 basis points as it felt upside risks to inflation were receding. The decision to cut rates was unanimous with all six members of the Monetary Policy Committee (MPC) voting in favour.
Since then, not only has inflation declined sharper than expected, the risks to it during the rest of the fiscal have also reduced. Inflation moderated to 4.2 percent, a one-year low, in October from 4.3 percent in September. This was driven by a drop in food inflation to 3.3 percent (or by 60 basis points) led by falling prices of vegetables, fruits and pulses. Core inflation, on the other hand, edged up to 5.1 percent.
The positive impact of a good monsoon this year is already reflecting in lower food prices. Demonetisation, we believe, will curb demand and ease inflation in the short run.
The downward pressure on prices due to lower demand will be felt more in the rural areas and for sectors such as housing, transport and food, where the share of cash transactions is high. A sharper fall in rural inflation compared with urban is on the cards. And the decline in demand should bring down core inflation as well. Sure, there is some risk of rise in the imported component of inflation due to the rupee weakening, but this will be outweighed by factors pulling inflation down.
We now see average inflation in this fiscal at 4.8 percent compared with our earlier forecast of 5 percent.
The Liquidity Picture
Monetary transmission, too, is expected to improve. Excess liquidity in the banking system following demonetisation would drive interest rates down. The unprecedented surge in liquidity forced the RBI to raise the cash reserve ratio (CRR) to 100 percent of incremental net time and demand liabilities between September 16 and November 11, 2016. This has temporarily stemmed the rally in bond markets.
Yields on the 10-year benchmark government security has already fallen ~60 basis points since November 8. Those on certificates of deposit and commercial paper, and bank deposits, have slipped, too. With the risk-free rate in the economy and bank deposit rates falling sharply, bank lending rates should soon follow suit.
Coming back to monetary policy, this would be the second review where the MPC will decide on interest rates. Members of the committee hardly got a chance to do a nuanced analysis on October 4, because the committee itself was formed only a few days before the policy. This time, they have had more time but the economic environment has become far more difficult to assess. The minutes of MPC and its prognosis of the economy, will, therefore, be closely watched.
Dharmakirti Joshi is chief economist at CRISIL.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.