Suyash Choudhary

The Monetary Policy Committee (MPC) delivered a unanimous 25 bps rate cut as well a change in stance to accommodative. CPI forecast has been marginally revised upwards for H1 FY 20 to 3 – 3.1% (2.9 – 3% earlier), but is a shade lower for H2 at 3.4 – 3.7% (3.5 – 3.8% earlier). The commentary notes upside pressure to food prices but a broad based decline in core inflation on the back of ‘significant’ weakening of demand conditions. Crude prices are volatile but near term inflation expectations of households have continued to moderate. Acknowledging slowdown in growth drivers Gross Domestic Product (GDP) forecast is revised lower to 6.4 – 6.7% in H1 (6.8 – 7.1% earlier) and 7.2 – 7.5% in H2 (7.3 – 7.4%). The MPC notes that “growth impulses have weakened significantly as reflected in a further widening of the output gap compared to the April 2019 policy”.

 

We had discussed in a recent note (please refer https://www.idfcmf.com/insights/transmission-impossible-a-discussion-on-monetary-policy/ ) three items that monetary policy could have addressed in order to improve transmission. These were 1> better utilization of the guidance tool in terms of changing stance 2> redrafting the Consumer Price Index (CPI) target framework to make it more targetable by, as an example, linking it to a real rate framework. 3> revisiting the stance on liquidity. We are happy to note that with the policy today and in the run up to it, two out of these three have been largely adopted. Thus the stance has been made explicitly accommodative. In our view it has been a misinterpretation to view a change in stance to be unnecessary this late in the cycle. Rather it was an underutilization of a potent  policy tool that has now been rectified. The RBI seems to also have de-facto adopted a positive liquidity stance. This is evident in core liquidity having been turned positive some time back and yet the RBI having persisted with further injection tools including an OMO that is scheduled for mid June. Now with government spending happening, the headline liquidity is positive too. Further, an internal  working group has been  constituted to review comprehensively the existing liquidity management framework and suggest measures, among others, to (i) simplify the current liquidity management framework; and (ii) clearly communicate the objectives, quantitative measures and toolkit of liquidity management by the Reserve Bank. The Group is expected to submit its report by mid-July 2019.

 

The one aspect that we have been disappointed with is the continued insistence not to anchor monetary policy to some sort of a better defined real rate framework. The Governor was emphatic in saying that observers will have to deduce this via RBI /MPC actions and that he would not commit to anything on this point. However, so long as the absence of this framework doesn’t impart a systematic hawkish bias to policy (as seems to have been the case in the past), this may not be a constraint at least in the near term.

 

The other notable aspects of the press conference post policy are as follows:

 
1. The Governor seems to have a reasonably benign view on government finances. Thus he underplayed the recent stress instead focusing on the consolidation underway over the past few years. Furthermore, he also doesn’t seem to be unduly concerned about PSU borrowings saying that borrowings done by PSUs who have own revenue streams shouldn’t be looked upon as government borrowing. This is somewhat surprising since the common perception is that at least some part of the heavier than usual PSU borrowings recently has been to compensate for lack of budget resource availability. Similarly the heavier usage of small savings was similarly not considered to be a very sticky point.
 
2. Given very large buffer stocks (3.4 times prescribed norm), there seems to be less of a concern from an inflation perspective, in case monsoons turn out to be weaker. This is the right approach and in fact we have argued one step further to say that even if prices were to rise on the back of a supply shock, they are unlikely to have second round effects and hence are unlikely to be relevant from a monetary policy standpoint.
 
3. A welcome clarification has been provided with respect to state development loans (SDL) with the Governor explicitly stating that they have implicit sovereign guarantee and that the RBI automatically debits state accounts at time of payment. This is relevant since a recent push by RBI towards asking states to get rated was somewhat muddying the risk perception, since a question could always be asked as to what the importance of rating was for a sovereign backed asset? The clarification now provided conclusively clears the air.

 

Implications

 

World growth expectations have taken a decided turn towards the worse over the past month or so. This is now reflected in expectations of easing by major central banks later in the year. As an example, the US yield curve is now reasonably inverted upto 10 years with market expecting 2 – 3 rate cuts in the future. Locally as well there has been a  marked deterioration in growth drivers with consumption being the latest casualty, probably courtesy an impact to leverage given the ongoing stresses in certain parts of the financing market. Thus the current monetary easing underway has to be looked at in this overall context. While currently the expectation would be for one last rate cut alongside continued easy liquidity, this can very quickly change towards expecting a deeper further easing should the global outlook further deteriorate.

 

The next major domestic trigger is going to be the Union Budget in early July. Given the large undershoots in the actual revenue collections in FY 19 versus even the revised numbers presented in February, the numbers targeted in the interim budget are looking truly daunting. This is especially in context of the ongoing growth slowdown. Thus the new finance minister will have a tall task to present a credible budget while sticking to the assumed deficit target. In this context the Jalan committee’s report on potential excess RBI reserves and their usage by the government will assume importance.

 

From a bond market standpoint, the focus should remain on quality rates (sovereign, SDL, AAA) as the best vehicles to play the current macro environment. As developments continually highlight, the lower rated credit markets are far from settled and the spreads that can effectively be captured there may not yet be compensating for the risks involved.

 

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