RBI Needs To Use Tools Other Than CRR On Excess Liquidity: Morgan Stanley
As we enter the new financial year, the first key scheduled policy announcement will be that of the monetary policy review by the Reserve Bank of India, due on April 6. Having shifted to a neutral policy stance in the February meeting, what will the RBI announce and how will the monetary policy stance evolve as the financial year progresses?
Since the February policy meeting, the incoming growth and inflation data have evolved largely in line with the monetary policy committee's assessment. On growth, the committee had highlighted that it expects the effects of the currency replacement program to wear off and thus the drag on economic activity should reduce. Indeed, both passenger car and two-wheeler sales growth – which we use as proxies of urban and rural consumption – have improved in the last two months. Moreover, external demand conditions have been more conducive for growth too, with exports growth staying positive for the sixth consecutive month and accelerating to a 64-month high of 17.5 percent year-on-year growth in February.
On the inflation front, the new information that the committee has received is also in line with its earlier expectations. The normalisation in food prices has led to an uptick in Consumer Price Index inflation to 3.7 percent year-on-year in February but nonetheless remains in line with what the committee had projected in its previous policy statement.
These data points dovetail with the RBI’s assessment that both growth and inflation will pick up in the financial year 2017-18 (FY18). Indeed, considering that there have been no significant surprises in the incoming data, we do expect the RBI to retain its assessment that growth and inflation will pick up in FY18.
More importantly, considering that the RBI has just shifted to a neutral stance in its last policy review, we believe that key policy rates, including the cash reserve ratio, will be kept unchanged at this meeting.
Managing Liquidity
Of late, there has been intense focus on the potential introduction of new tools to better manage liquidity conditions. One tool reportedly under consideration is a standing deposit facility (SDF), which had earlier been proposed in the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework. This facility would allow the central bank to withdraw liquidity without having to post collateral, effectively removing the constraints that the RBI would have to operate under, if it were to withdraw liquidity via using reverse repos as it would have to post government securities as collateral to banks when engaging in reverse repo operations. Such a tool would help in effective liquidity management by reducing interest rate volatility.
Regardless of whether the central bank would introduce new tools, we do think that it will have to take measures - other than cash reserve ratio hikes - to absorb the excess liquidity to ensure that the call rate moves closer to the repo rate.
Even though the central bank had shifted its policy stance to neutral, the call rate has been trading below the repo rate due to the surplus liquidity. A cash reserve ratio hike could be used to absorb the excess liquidity but would signal a tightening stance instead of the current neutral stance. Moreover, considering that liquidity conditions tend to be more favourable in the first half of the fiscal year, we do think that the central bank will have to take steps to absorb the excess liquidity to ensure that the call rate moves closer to the repo rate.
Rate Hike Likely In Late 2018
As the fiscal year progresses, we think that the RBI will gradually shift its tone towards a hawkish one, eventually paving the way for a rate hike in the second half of the calendar year 2018.
This is predicated on the view that the economy evolves according to our base case and also the RBI's narrative that growth recovers further and inflation picks up as food prices normalise.
The key reasons underpinning this shift are that the economy will be embarking on a fully fledged recovery, with domestic private capital expenditure picking up by January-March 2018, against the external backdrop that the Fed will be taking its interest rates higher over the course of the forecast horizon. As consumption and exports pick up further, capacity utilisation rates should improve and the central bank would, therefore, need to start lifting rates in a pre-emptive manner from the second half of 2018.
If the recovery is stronger than expected, it may bring forward the timing of a rate hike. The other risk to the call will be the inflation outlook. While as of now, the government has been restrained in growing its expenditures, there is a potential risk that government expenditure - particularly in redistributive spending - could rise as we head into 2018, a year ahead of the general elections. This could bring upside risks to inflation and press the case for a rate hike.
Chetan Ahya is Morgan Stanley’s co-head of global economics and chief Asia economist, Derrick Kam is the India economist.
The views expressed here are those of the authors’ and do not necessarily represent the views of Bloomberg Quint or its editorial team.