Commentary: MPC – First Bi-Monthly Statement FY20

The Monetary Policy Committee (MPC) has cut Repo by 25 bps to 6%, consequently impacting the Reverse Repo, which is now 5.75%. This is the second time the RBI has cut rates in the calendar year; the move is reflective of the economy’s deflationary tendencies. Inflation has been trending lower than the MPC’s estimates by a wide margin. February CPI number for instance barely crossed the 2.5% mark and expectations remain well below the target of 4% (±2%). Given the conditions prevailing in the food and fuel categories, the committee estimates CPI to remain in the 2.9%-3% (previously, 3.2-3.4%) and 3.5-3.8% range for H1 and H2 FY20, respectively. Even Q4 FY18 estimates have been revised downwards to 2.4% (previously, 2.8%). The upper range signifies the risk originating from lower than anticipated food production along with a developing uncertainty, curtesy El Nino. OPEC and Russian production cuts in confluence with a sudden global recovery may also lead to an upward bias for the headline number.

Notwithstanding, the assessment is in-line with a 40 bps decline in respondent inflation expectations over a one-year horizon as part of RBI’s forward surveys. While the MPC notes the somewhat sticky core inflation, which is pegged in the vicinity of 5.5%, concerns regarding falling import and domestic production of capital goods overwhelm any hawkish narrative. At 1.3%, the growth in IIP for January 2019 has been disappointing and is largely kept in the black via expenditure on infrastructure. Despite this, improvement in business sentiment along with improving capacity utilization (CU) levels have been duly noted.

In the absence of any significant activity in the capital markets, credit offtake has been very strong and has outpaced the deposit growth. The mismatch has resulted in an adverse credit to deposit ratio and severe systemic liquidity concerns. To sooth the shortfall, the RBI has infused nearly Rs. 3 lakh crore through its Open Market Operations (OMO) in FY19 and Rs 0.95 lakh crore (net infusion daily) in the month February through its Liquidity Adjustment Facility (LAF). The central bank’s third avenue in the name of currency swap, infused an incremental Rs. 34,500 crores in the system. These measures have effectively shored up the deficit in the system and brought a sense of normalcy in the call money market.

Talking from the aggregate demand perspective, the committee is mind-full of Gross Fixed Capital Formation (GFCF) to GDP ratio, which has now reached 33.1% in Q3 FY19 as compared to 31.8%, same time previous year. However, declining exports have been a matter of concern since the variable becomes less effective in neutralizing the effects of a deficit economic structure. The fall here can be attributed to moderating oil prices, which are in turn also impacting the import bill as well. Consequently, the trade deficit declined to $9.5 billion in February this year; a figure that is 17 month-low. Overall, the FY19 GDP number is impacted negatively shaving the fiscal year’s growth by 20 bps.

In terms of the external sector, the MPC believes that much of the Developed as well as Emerging world is undergoing a slowdown and this has significant ramifications for India. The currency (INR) has seen some downward pressures lately but adequately compensated by strong foreign inflows given rate normalizations on hold in the US, EU and Japan. This is precisely the reason why we see this rate cut as a rare opportunity for the MPC to frontload. We reckon that this window will close soon given declining yield differentials between DM and EM debt – a situation that will worsen as and when normalizations/ taper tantrums return.