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Monetary Policy Update

Oct 4, 2019

The Key to an Economic Recovery

The Reserve Bank of India today decided to reduce the policy repo rate to 5.15% from 5.40% with five members voting in favour of a 25bps cut and one member voting in favour of a 40bps cut. The MPC decided to keep the monetary policy stance unchanged at “accommodative” with an objective of achieving a medium-term target for CPI of 4% within a band of ± 2%, while supporting growth.

Key highlights of the RBI’s Monetary Policy

The MPC’s inflation expectations remain broadly unchanged:

• 3.4% for Q2FY20 (vs. expectation of 3.1% earlier)
• 3.5-3.7% for H2FY20 (retained earlier guidance)
• 3.6% for Q1FY20 (retained earlier guidance)

The GDP growth rates expectations trimmed down again as various high frequency indicators suggest weak demand:

• 6.6-7.2% for H2FY20 (vs 7.3-7.5% earlier)
• 6.1% in FY20 (vs 6.9% earlier)
• 7.2% in Q1FY21 (vs. 7.4% earlier)

Rationale for a Rate Cut

In listing its rationale for a rate cut, the RBI flagged weakness in global economic activity, elevated trade tensions and geo-political uncertainty. Among advanced economies, the RBI noted that the slowdown witnessed in Q2 seems to have extended into Q3 as well. Growth in emerging market economies has been weighed down by a deteriorating global environment as well.

The Chinese economy’s growth also continued to remain tepid in Q3, due to weak domestic demand and contraction in exports. In Russia, though economic activity ticked up in Q2, subdued consumer sentiment and weak industrial production may restrain momentum.

Slowing Domestic Activity

Domestically, GDP growth decelerated for a fifth consecutive quarter to 5.0% in Q1FY20. However, amidst the gloomy news, rainfall data shows some silver lining with cumulative all-India rainfall at 10% above long period averages. As a result, the prospects for agriculture have brightened considerably, and therefore, the rural economy.

IIP continued to moderate in July pulled down by manufacturing. Production of coal, electricity, crude oil and cement contracted in August. Capacity utilisation levels have failed to pick up with the latest reading at 73.6%, in line with slow growth in manufacturing activities. However, the manufacturing purchasing managers’ index was unchanged MoM. The services PMI moved into contraction in September 2019, dragged down mainly by a decline in new business inflows.

High frequency indicators present a dull picture with contraction across segments. Tractor and motorcycle sales – indicators of rural demand – continue to contract. Amongst indicators of urban demand, passenger vehicle sales continue to contract as well. Sales of commercial vehicles, a key indicator for the transportation sector, contracted by double digits in July-August. Surprisingly, domestic air passenger traffic growth shows a completely different picture with an acceleration in August.

Retail inflation, measured by CPI, moved in a narrow range of 3.1- 3.2% between June and August. While food inflation picked up, fuel prices moved into deflation. Inflation excluding food and fuel softened in August.

While, the rate cuts have been steep with cumulative rate cuts of 135bps since Feb 2019, transmission of rate cuts to end consumer has not kept pace. The weighted average lending rate on fresh rupee loans of commercial banks has declined by only 29 bps while, the WALR on outstanding rupee loans increased by 7 bps during the same period.

The trade deficit narrowed during the quarter despite weak exports as a fall in gold import volumes and lower crude prices led to a decline in the import bill. Net FDI inflows rose to USD17.7bn during April-July’ 2019 from USD11.4bn a year ago. On the FPI side, after seeing steep outflows over last few months, we have started seeing positive flows in September. India’s foreign exchange reserves were at USD434.6 bn as on Oct 01, 2019.

Market Reaction

• The yield on the 10 year government bond is flat today. The yields have risen ~30bps in the last three months, but come off highs in recent days, again signalling economic weakness.
• The Indian rupee depreciated marginally to 71 per Us dollar.


Near Term Volatility due to Uncertainties on Growth

Markets are dealing with worries on global growth, and domestic growth, as well as dealing with bad loans and stressed entities. Worries related to stressed financials will resolve in coming weeks. Correspondingly, the first benefits of rate cuts should begin kicking in some time early next year. We can expect further action on the fiscal policy front.

Consumption is the Key to an Economic Recovery

The one item missing, however, and the most important item, is to support the struggling consumer. The corporate tax cut will flow to corporate bottom lines, but will not necessarily revive the economy. The measures announced have been critical in supporting the markets and improving confidence, but consumption stimulus is critical, alongside monetary transmission.

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