Indian economic growth, as measured by the gross value added metric, remained steady at 7.2 per cent in the first half of this fiscal, in line with the trend in H1 FY2016. The CPI inflation peaked at 6.1 per cent in July 2016, crossing the 2-6 per cent inflation target band notified by the Government of India (GoI). However, inflation subsequently softened to a 14-month low of 4.2 per cent in October 2016, led by a considerable fall in food inflation.
As the festival season drew to a close, the prevailing expectation was that a surge in rural cash flows, after the healthy harvest and additional disposable income in the hands of Central Government employees and pensioners, would further improve consumption growth in H2 FY2017. However, November 2016 turned out to be a turbulent month for the Indian economy, up-ending the calculations of businesses and other market participants.
The withdrawal of the legal tender status for the existing notes of ₹500 and ₹1,000 from November 9, accounting for around 85 per cent of the value of bank notes in circulation, is expected to curb illegal transactions, reduce the incidence of black money and transition India to a less cash-dependant society over the medium term. However, the cash liquidity crunch has tempered consumer confidence, which is likely to weaken domestic consumption growth, corporate earnings and indirect tax revenues in the ongoing quarter. On the upside, curtailed economic activity would dampen inflation, particularly for big-ticket and discretionary items.
The Reserve Bank of India (RBI) has indicated that between November 10, 2016 and November 27, 2016, ₹8.1 trillion was deposited into banks, ₹0.3 trillion was exchanged into new currency notes, and ₹2.2 trillion was withdrawn from bank accounts. With limited avenues for stepping up lending, this surge in systemic inter-bank liquidity led banks to deposit excess funds with the RBI at its reverse repo window, and purchase bonds. The latter led to a sharp correction in bond yields, which would reduce the interest outgo for borrowers on incremental funds raised through the debt markets.
The accumulation of deposits was also expected to dampen the cost of bank funds and transmit to lower lending rates.
However, the RBI subsequently introduced a temporary requirement to maintain 100 per cent cash reserve ratio (CRR) on the incremental net demand and time liabilities (NDTL) between September 16, and November 11, 2016, which would effectively impound ₹3.4 trillion of deposits. This has resulted in a small rise in bond yields, which had intermittently fallen below the repo rate.
The CRR hike may not earn the banks anything on those deposits, while continuing to pay interest on them, hindering transmission to lower lending rates. But, the ceiling for the market stabilisation scheme has now been hiked to ₹6 trillion. This, coupled with the government securities’ stock in excess of ₹7 trillion held by the RBI, and the new currency withdrawal of over ₹2.5 trillion, suggests that the CRR hike to absorb excess liquidity is no longer needed. Hence, the temporary CRR hike may be reversed with effect from the next reporting Friday.
With sticky bank lending rates and moderate capacity utilisation, private sector investment decisions may get deferred further. The pace at which cash liquidity improves and people switch to cashless transactions would crucially impact growth in H2 FY2017.
Fiscal measures may not helpIn the prevailing situation, fiscal measures introduced by the government may have a limited impact on stimulating demand in the immediate term.
However, the moderation in demand is likely to ensure that the CPI inflation undershoots the RBI’s March 2017 target of 5 per cent, allowing for a stimulus by way of a 50 bps rate cut up to June 2017.
In our view, there is a high likelihood of a 25 bps cut in the repo rate on December 7, which would support sentiments amidst the temporary slowdown in economic activity. The RBI may also indicate a timeline and magnitude of issuance of bonds or short term bills under the Market Stabilisation Scheme, to absorb the excess liquidity.
The combination of a rate cut and clarity on liquidity management would be a signal for banks to enhance transmission, giving them greater comfort to lower deposit and lending rates, which would protect the banks’ own net interest income and benefit borrowers, respectively. A rate cut would have a mixed impact on foreign institutional investors (FII) flows; lower domestic rates would hasten debt outflows, while an improved outlook for consumption and corporate earnings would arrest equity outflows.
The upcoming RBI policy is also likely to provide a time-frame for increased cash liquidity. Ultimately, quicker re-infusion of cash in the economy would boost sentiment and revive consumption faster than fiscal or monetary stimulus measures.
The writer is Managing Director and Group CEO, ICRA