Analysis. Softer tone likely on monetary policy

CPI inflation has remained below 4 per cent, i.e. the medium-term target set by the Monetary Policy Committee (MPC) of the Reserve Bank of India for six consecutive months.

Moreover, several of the inflation risks highlighted by the MPC in April 2017 have subsequently eased due to positive factors like the improved monsoon outlook, rate structure of the Goods and Services Tax (GST) and easing of commodity prices.

At the same time, post-remonetisation, several sectors have displayed improvement in volume growth although we are yet to witness a broad-based revival in private sector investment.

Following the record harvest in FY2017, the improved monsoon prospects have reduced concerns related to food inflation. There are, however, modest risks that remain pertaining to the dip in reservoir levels, extent of revision in minimum support prices (MSPs) and sticky rural wage inflation.

Additionally, the impending revision in house rent allowance, based on the Seventh Pay Commission’s recommendations, will push up housing inflation.

With GST set to roll from July 1, many food items and services such as education and healthcare will be tax-exempt. Moreover, the effective tax rate for most goods after adjusting for input tax credit and removal of cascading is likely to remain stable or ease, post-GST.

However, some corporates may face a higher effective tax rate depending on the pending decisions regarding area-based exemptions. While the rate for several services will rise to 18 per cent or 28 per cent from 15 per cent, input tax credit may soften the impact of the GST on services inflation.

Overall, ICRA expects the impact of GST on CPI inflation to be modest, although there are some concerns regarding the revenue buoyancy for the Centre due to the GST rate structure.

ICRA expects the average CPI inflation to ease from 4.5 per cent in FY2017 to 4.0-4.3 per cent in FY2018, although it is likely to rise in H2 FY2018. Before reducing the policy rate or reversing the stance back to accommodative from neutral, the MPC may prefer to observe the progress of the monsoon and the impending adjustment during the transition to the GST.

While ICRA expects the MPC to maintain status quo on the repo rate in the June 2017 review, its tone is likely to be less hawkish than the April 2017 policy document and minutes of the MPC meeting, which may lead to some softening of bond yields.

The year-on-year (YoY) expansion in bank deposits (12.1 per cent) continues to sharply outpace credit offtake growth (6.4 per cent) as on May 12, 2017. It is not surprising, therefore, that systemic liquidity remains in surplus mode.

Meanwhile, foreign exchange reserves rose by $4 billion to an all-time high of $379 billion for the week ending May 19, 2017, suggesting the possibility that the central bank may have intervened to prevent the US$-INR cross rate from strengthening past 64 in mid-May 2017, following sustained FII inflows.

The continued purchases of foreign currency assets by the RBI in the spot market will further infuse rupee liquidity, thereby complicating liquidity management.

With the Insolvency & Bankruptcy Code requiring time-bound decisions, the ordinance issued recently by the Centre and the discussions being held by the RBI with stakeholders will accelerate the process of resolution for banks’ stressed assets.

However, consensus needs to be reached on key issues such as the role of various stakeholders, the extent of haircuts to be taken by banks and fresh equity to be brought in by promoters. We foresee short-term pain before resolution is achieved, and an inevitable increase in the government’s budgetary allocation for recapitalisation of public sector banks (PSBs), particularly if large haircuts lead to losses.

The magnitude of funds raised by the Centre through disinvestment and divestment, as well as the revenue buoyancy post-GST, will crucially affect the fiscal space for recapitalising PSBs.

Based on the PSBs’ weak capitalisation and the relatively attractive pricing offered by the debt markets for better rated corporates, ICRA expects YoY bank credit growth to rise modestly to 7-8 per cent during FY2018.

However, the buoyant debt capital market will ensure that aggregate credit expands by a healthier 12 per cent during FY2018, provided, inflows in key investor segments such as mutual funds and insurance companies continue, which will allow competitive rates to be offered for corporate bonds and commercial paper.

The writer is Managing Director and Group CEO, ICRA

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