As expected, the Reserve Bank of India (RBI) cut its key policy repo rate by 25bp to 6.50% on 5 April 2016. Alongside the rate cut, the RBI is targeting better liquidity and monetary policy transmission, which should help accelerate India’s economic recovery.
A widely expected move
The 25bp repo rate cut was widely expected by financial markets. By January 2016, Consumer Price Index (CPI) had met the central bank’s target of 6% and now seems on track to be at 5% by March 2017. Moreover, the budget announced on 29 February supported the government’s commitment to fiscal consolidation. Despite the pressure on expenditure from the implementation of the 7th central pay commission, the budget maintained the government’s fiscal reduction targets aiming for a deficit of 3.5% of GDP for FY2017, down from 3.9% for FY2016.
Exhibit 1: CPI inflation has been in line with the RBI's target
Exhibit 2: Indian fiscal deficit
A rate cut, but not only
As well as the rate cut, the RBI has also taken several steps to improve liquidity and transmission. While the cash reserve ratio (CRR) was unchanged, the minimum daily CRR was reduced from 95% to 90%. Additionally, the Marginal Standing Facility (MSF) rate was reduced by 75bp to 7% and the reverse repo rate was increased by 25bp to 6%, leading to a narrowing of the policy rate corridor from +/-1% to +/-50bp around the repo rate.
These measures to improve liquidity, combined with the recent introduction of the marginal cost of funds-based lending rate (MCLR) on 1 April 2016, are likely to lead to better monetary transmission. Since the implementation of the MCLR, fresh lending rates have already declined by around 25bp and are expected to decline further following today’s measures.
Monetary policy to remain cautiously accommodative
Following this rate cut, the RBI is likely to remain cautiously accommodative. In assessing further moves, the RBI will monitor a) the CPI inflation trajectory along with the 5% target by March 2017; b) monsoon development as deficient rainfalls could lead to higher food inflation; c) the inflationary impact of the roll-out of the 7th pay commission; and d) evidence of transmission of prior policy rate cuts into lower lending and deposit rates.
In light of the inflation dynamics and RBI’s targeting of 1.5%-2% positive real rates, there may be room for another 25bp rate cut later this year, pending sufficient monsoons occurring.
Impact on the economy and markets
Following the rate cut, banks are expected to lower their deposit rates, which may lead to more domestic investors shifting part of their assets from deposits to equities, providing some support to the Indian equity market (click here to read our blog note from October 2015 on the role of domestic investors in Indian equities).
More broadly, the accommodative monetary policy stance – with a focus on improving liquidity and policy transmission – is expected to help India’s economic recovery, especially as lower lending rates should lead to a pick-up in credit growth. The RBI continues to expect India to grow at 7.6% as measured by Gross Value Added (GVA) for the financial year ending in March 2017 (FY 2017), the fastest growth rate among large economies.
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