RBI to shortly finalise the methodology for determining the base rate based on the marginal cost of funds
The Reserve Bank of India (RBI) has kept the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.75% at its fifth bi-monthly monetary policy review. The cash reserve ratio (CRR) of scheduled banks was also maintained unchanged at 4.0% of net demand and time liability (NDTL);Global Economy
Global growth continues to be weak. Global trade has slowed further with waning demand and oversupply in several primary commodities and industrial materials.
Global financial markets began Q4 on a calmer note after the Federal Open Market Committee stayed on hold in September.
Stock markets recorded modest gains in October; major currencies recouped some ground against the US dollar and crude oil traded briefly above US $ 50 per barrel for the first time since July.
Currency markets in EMEs have experienced selling pressures as portfolio investors continue to exit them as an asset class.
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Unease in investor sentiment is likely to increase ahead of the imminent divergence in advanced economy monetary policy stances.
Domestic Economy
Estimates of gross value added (GVA) at basic prices for Q2 of 2015-16 rose on the back of acceleration in industrial activity. Other indicators suggest the economy is in the early stages of a recovery, though with some areas of continued weakness.
The current outlook for agricultural growth in 2015-16 appears moderate at best at this juncture.
It remains to be seen whether growing public investment can crowd in private investment on a sustained basis, despite the still-low capacity utilisation.
Lead indicators of services sector are mixed. Recent policy initiatives relating to rail, port and road projects are likely to improve construction activity, as will the Reserve Bank's countercyclical reduction of capital charges on low income housing loans, albeit with gestation lags.
Inflation
Retail inflation measured by the consumer price index (CPI) increased for the third successive month in October 2015, pushed up by a surge in the monthly momentum.
Households' inflation expectations remain elevated although they have edged lower recently, perhaps in response to lower prices of petrol and diesel. Rural wage growth, as also corporate staff costs, remain subdued.
Liquidity
Underlying liquidity conditions tightened in October-November with the festival season draining currency from the system and some slowdown in government expenditure.
Money market rates remained around the policy repo rate - only rising slightly in the second week of November at the height of festival currency demand.
Bank credit in the form of personal loans grew strongly as did non-bank financing flows particularly through commercial paper, public equity issues and housing finance.
External sector
Exports contracted for the eleventh month in a row to October 2015, indicative of the persisting weakness in global trade.
Net foreign direct investment (FDI), external commercial borrowings and accretions to non-resident deposits have risen in relation to last year; however, portfolio outflows from both debt and equity segments rose in November.
Policy Stance and Rationale
In the bi-monthly monetary policy statement of September, the Reserve Bank assessed that the inflation target for January 2016 at 6 per cent was within reach.
Inflation has turned up as anticipated, and is expected to rise further until December before plateauing. Inflation is expected to broadly follow the path set out in the September review with risks slightly to the downside.
The growth projection for 2015-16 has accordingly been kept unchanged at 7.4% with a mild downside bias.
The implementation of the Pay Commission proposals, and its effect on wages and rents, will also be a factor in the Reserve Bank's future deliberations, though its direct effect on aggregate demand is likely to be offset by appropriate budgetary tightening as the Government stays on the fiscal consolidation path.
In the meantime, since the rate reduction cycle that commenced in January, less than half of the cumulative policy repo rate reduction of 125 bps has been transmitted by banks. The median base lending rate has declined only by 60 bps.
The Reserve Bank will shortly finalise the methodology for determining the base rate based on the marginal cost of funds, which all banks will move to.
The Government is examining linking small savings interest rates to market interest rates. These moves should further help transmission of policy rates into lending rates.
In addition, the on-going clean-up of bank balance sheets will help create room for fresh lending.
The Reserve Bank will use the space for further accommodation, when available, while keeping the economy anchored to the projected disinflation path that should take inflation down to 5% by March 2017.
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