On the basis of an assessment of the current and evolving macroeconomic situation at its meeting today, the Monetary Policy Committee (MPC) decided to: keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.25 per cent. Consequently, the reverse repo rate under the LAF remains unchanged at 5.75 per cent, and the marginal standing facility (MSF) rate and the Bank Rate at 6.75 per cent.
The decision of the MPC is consistent with an accommodative stance of monetary policy in consonance with the objective of achieving consumer price index (CPI) inflation at 5 per cent by Q4 of 2016-17 and the medium-term target of 4 per cent within a band of +/- 2 per cent, while supporting growth. The main considerations underlying the decision are set out in the statement below.
Global growth picked up modestly in the second half of 2016, after weakening in the first half. Activity in advanced economies (AEs) improved hesitantly, led by a rebound in the US. In the emerging market economies (EMEs), growth has moderated, but policy stimulus in China and some easing of stress in the larger commodity exporters shored up momentum. World trade is beginning to emerge out of a trough that bottomed out in July-August and shows signs of stabilising. Inflation has ticked up in some AEs, though well below target, and is easing in several EMEs. Expectations of reflationary fiscal policies in the US, Japan and China, and the waning of downward pressures on EMEs in recession are tempered by still-prevalent political risks in the euro area and the UK, emerging geo-political risks and the spectre of financial market volatility.
International financial markets were strongly impacted by the result of the US presidential election and incoming data that raised the probability of the Federal Reserve tightening monetary policy. As bouts of volatility fuelled a risk-off surge into US equities and out of fixed income markets, a risk-on stampede pulled out capital flows from EMEs, plunging their currencies and equity markets to recent lows even as bond yields hardened in tandem with US yields. The surge of the US dollar from late October intensified after the election results and triggered sizable depreciations in currencies around the world. Commodity prices firmed up across the board from 2 mid-November on an improvement in the outlook for demand following the US election results, barring gold which lost its safe haven glitter to the ascendant US dollar. Crude prices have firmed after the OPEC’s decision to cut output.
On the domestic front, the growth of real gross value added (GVA) in Q2 of 2016-17 turned out to be lower than projected on account of a deeper than expected slowdown in industrial activity. Manufacturing slowed down both sequentially and on an annual basis, with weak demand conditions and the firming up of input costs dragging down the profitability of corporations. Gross fixed capital formation contracted for the third consecutive quarter. Although government final consumption expenditure slowed sequentially, it supported private final consumption expenditure, the mainstay of aggregate demand. The contribution of net exports to aggregate demand remained positive, but on account of a sharper contraction in imports relative to exports.
Turning to Q3, the Committee felt that the assessment is clouded by the still unfolding effects of the withdrawal of specified bank notes (SBNs). The steady expansion in acreage under rabi sowing across major crops compared to a year ago should build on the robust performance of agriculture in Q2. By contrast, industrial activity remains weak. Among the core industries in the index of industrial production (IIP), the output of coal contracted in October due to subdued demand, while the production of crude oil and natural gas shrank under the binding constraint of structural impediments. The production of cement, fertilisers and electricity continued to decelerate, reflecting the sluggishness in underlying economic activity. On the other hand, steel output has recorded sustained expansion following the application of countervailing duties. Refinery output accelerated on the back of a pick-up in exports and capacity additions. The withdrawal of SBNs could transiently interrupt some part of industrial activity in November-December due to delays in payments of wages and purchases of inputs, although a fuller assessment is awaited. In the services sector, the outlook is mixed with construction, trade, transport, hotels and communication impacted by temporary SBN effects, while public administration, defence and other services would continue to be buoyed by the 7th Central Pay Commission (CPC) award and one rank one pension (OROP). GVA by financial services is expected to receive a short-term boost from the large inflow of low-cost deposits.
Retail inflation measured by the headline consumer price index (CPI) eased more than expected for the third consecutive month in October, driven down by a sharper than anticipated deflation in the prices of vegetables. Underlying this softer reading, however, was an upturn in momentum as prices rose month-on-month across the board. Still elevated prices of sugar and protein-rich items, coupled with a turning up of prices of cereals, pulses and processed foods pushed up the momentum of food prices, which partly offset the moderation in food inflation brought about by a strong favourable base effect. In the fuel category, inflation eased with the decline in LPG prices on an annual basis and a fall in electricity prices from a month ago. Inflation excluding food and fuel continues to show strong persistence. Although housing and personal care inflation softened marginally, the steady rise in inflation in respect of education, medical and health services, and transport and communication has imparted stickiness to inflation in this category.
Liquidity conditions have undergone large shifts in Q3 so far. Surplus conditions in October and early November were overwhelmed by the impact of the withdrawal of SBNs from November 9. Currency in circulation plunged by '7.4 trillion up to December 2; consequently, net of replacements, deposits surged into the 3 banking system, leading to a massive increase in its excess reserves. The Reserve Bank scaled up its liquidity operations through variable rate reverse repo auctions of a wide range of tenors from overnight to 91 days, absorbing liquidity (net) of '5.2 trillion. The Reserve Bank allowed oil bonds issued by the Government as eligible securities under the LAF. From the fortnight beginning November 26, an incremental CRR of 100 per cent was applied on the increase in net demand and time liabilities (NDTL) between September 16, 2016 and November 11, 2016 as a temporary measure to drain excess liquidity from the system. From November 28, liquidity absorption fell back and the Reserve Bank undertook variable rate repo auctions of '3.3 trillion on November 28. As expected, money market conditions tightened thereafter and the weighted average call rate (WACR) traded near the upper bound of the LAF corridor on that day before dropping back to the policy repo rate on November 30. All other rates in the system firmed up in sympathy, with term premia getting restored gradually. Through this episode, active liquidity management prevented the WACR from falling even to the fixed rate reverse repo rate, the lower bound of the LAF corridor. Liquidity management was bolstered by an increase in the limit on securities under the market stabilisation scheme (MSS) from '0.2 trillion to '6 trillion on November 29. There have been two issuances of cash management bills under MSS for '1.4 trillion by December 6, 2016.
In the external sector, India’s merchandise exports rebounded in September and October. The return to positive territory was supported by a pick-up in both POL and non-POL exports. After a prolonged fall for 22 months, imports rose in October on the back of a sharp rise in the volume of gold imports and higher payments for POL imports. Non-oil non-gold import growth also turned positive after a gap of seven months. For the period April-October, the merchandise trade deficit was lower by US $ 25 billion from its level a year ago. Accordingly, the current account deficit is likely to remain muted, notwithstanding some loss of remittances and software exports under invisibles. Net foreign direct investment has remained reasonably robust, with more than half going to manufacturing, communication and financial services. By contrast, portfolio investment outflows of the order of US $ 7.3 billion occurred in October-November from both debt and equity markets – as in peer EMEs across the board – reflecting a strong home bias triggered by the outcome of the US presidential election and the near-certainty of monetary policy tightening in the US. The level of foreign exchange reserves was US$ 364 billion on December 2, 2016.