Decline in bank lending rates unlikely

Prolonged pause for repo rate is on the cards, given the RBI’s focus on inflation management

The new fiscal commenced with the first bi-monthly monetary policy statement for FY2018 from the Reserve Bank of India (RBI), which outlined some risks and the assessment for the new year.

While the six-member Monetary Policy Committee (MPC) of the RBI remains upbeat about the economic growth prospects for FY2018, it warned that inflation developments warrant continuous monitoring.

Accordingly, the main policy rate, namely the repo rate, was kept unchanged at 6.25 per cent. Moreover, the RBI highlighted that it would use a mix of tools to bring systemic liquidity closer to neutrality from the prevailing surplus conditions.

Risks to inflation

The MPC highlighted several risks to inflation, such as the impact of the upcoming monsoon on food prices. The declining reservoir level, particularly in several southern States, is a matter of concern, with early reports suggesting that the emergence of an El Nino could curtail rainfall.

Additionally, the introduction of the Goods and Services Tax (GST) could result in many prices being reset. Although the GST is intended to be revenue-neutral for the government, it may not necessarily be inflation-neutral, given the specific composition of the CPI basket.

The MPC has estimated that the increase in house rent allowance based on the recommendations of the Seventh Pay Commission would increase inflation by a substantial 1.0-1.5 per cent over a period of 12-18 months. The Committee expects CPI inflation to rise from 4.5 per cent in H1 FY2018 to 5 per cent in H2 FY2018, whereas it would like to see it brought down to 4 per cent in a durable manner, which suggests that a prolonged pause for the repo rate is forthcoming.

The MPC continues to expect growth of gross value added (GVA) to rise to 7.4 per cent in FY2018, from a downward revised 6.7 per cent in FY2017. This sharp uptick is expected to benefit from the pick-up in discretionary spending after remonetisation, the recent decline in lending rates, improved investor confidence after the passage of Bills such as the GST, higher government capital spending and export growth in an improving global environment.

Surplus liquidity

The surfeit of deposits after the note ban coincided with a fall in demand for bank credit, leaving the banking system with surplus liquidity. At present, around ₹4 lakh crore of excess liquidity is being absorbed by the RBI through overnight and term reverse repos.

While the repo rate was kept unchanged, the other overnight rates under the RBI’s liquidity adjustment facility were modified. The reverse repo rate was increased to 6 per cent from 5.75 per cent, and the marginal standing facility (MSF) rate was cut to 6.5 per cent from 6.75 per cent. This benefits banks, which would earn higher interest on excess liquidity offered at the reverse repo rate in times of surplus, and pay a lower rate to obtain funds from the RBI at the MSF rate in phases of deficit.

In FY2018, ICRA expects bank deposits and credit to grow around 6 per cent and 8 per cent, respectively. We estimate that incremental deposits would modestly exceed fresh credit offtake, which means that the liquidity surplus would need to be reduced through other means.

To do so, the RBI indicated that it would use a mix of instruments, including reverse repo auctions, operations under the market stabilisation scheme, issuance of short-term cash management bills and open market operations.

In the prevailing situation, the latter would entail the sale of the central bank’s holdings of government securities (G-Secs), absorbing liquidity in a permanent manner. However, the usage of this tool as well as other collateralised instruments such as overnight and longer tenure reverse repos is constrained by the stock of G-Secs held by the RBI. The central bank indicated that the introduction of a non-collateralised Standing Deposit Facility (SDF) is under consideration with the government, which would augment the liquidity management tool-kit.

The surge in liquidity during FY2017 brought down deposit rates by 80-200 basis points (bps) across tenures, and the one-year marginal cost of funds-based lending rate (MCLR) by 95 bps. Nevertheless, transmission to lending rates may not be complete. However, with the RBI expected to work toward reducing the liquidity surplus and a low likelihood of a repo rate cut, the scope for a further decline in bank lending rates in 2017 appears limited.

The writer is Principal Economist, ICRA Limited

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