RBI has also narrowed the policy rate corridor to 50bp from 100bp by reducing the marginal standing facility rate by 75bp and increasing the reverse repo rate by 25bp. This, according to the RBI, was done to ensure better alignment of the weighted average call rate with the repo rate. The repo rate, reverse repo rate, and marginal standing facility rate, therefore, stand at 6.5%, 6.0%, and 7.0%, respectively. The regulator has tried to address two key issues currently facing the banking sector - (i) tight liquidity and (ii) weak monetary transmission.
Liquidity Situation to Ease: Liquidity has remained stretched in the system since December 2015 due to a build-up of government cash balances with RBI and an increase in currency holdings with the public. Liquidity injection by RBI remained above INR2trn in March 2016. According to RBI, the effective policy corridor in 2HFY16 was +36/-27bp despite the tight liquidity conditions due to proactive liquidity management by the central bank. The central bank, therefore, has deemed appropriate the narrowing of the rate corridor. Ind-Ra believes this will impact borrowing costs positively as banks with surplus funds will be able to earn higher returns on funds parked with RBI and pass it on to borrowers by charging lower rates of interest. The narrowed policy rate corridor will also benefit banks that exhaust the repo window and have to meet their liquidity requirements using the marginal standing facility window.
Although RBI kept the cash reserve ratio at 4%, it has reduced the minimum daily maintenance requirement of the ratio to 90% from 95% to ease liquidity. This is likely to release about INR200bn into the system. RBI also has announced an open market operation of INR150bn. Ind-Ra believes these measures will not only address the tight liquidity in the system but also improve the monetary transmission. Monetary transmission will also be aided by the introduction of a marginal cost of funds based lending rate effective 1 April 2016.
Inflation to Remain Contained: Inflation trajectory has evolved broadly in line with RBI's expectation. The regulator expects consumer price inflation to moderate and remain around 5% during FY17 with small inter-quarter variations. RBI expects the direct impact of the 7th Central Pay Commission recommendations on the headline inflation to be around 150bp and indirect effects to be around 40bp. However, the central bank expects that the upside pressure will be offset by tepid demand in the global economy, effective supply side measures taken by the government that will keep a check on food inflation, and the adherence to fiscal consolidation by the central government.
Yields on Government Bonds to Soften: Following the policy move in RBI's first bi-monthly review, Ind-Ra expects the G-sec yields to soften over the coming months. Reduced corridor will enable RBI to manoeuvre frictional mismatches by allowing overnight rate to move in either direction. In an environment of limited flows, domestic liquidity has mostly been into the deficit zone, which necessitated more liquidity infusion than absorption. Ind-Ra expects the liquidity to improve in 1HFY17, with possibilities of some liquidity crunch in 2H. In the event of tepid foreign flows, open market operation purchases will smoothen the otherwise lopsided demand-supply equation on the statutory liquidity ratio bonds' front.
Volatility to Resume in OIS Market: Overnight index swap (OIS) market closely tracks overnight rates, and has been stable because of RBI's endeavour to curb volatility by way of multiple tools along with announcement effects. However, Ind-Ra believes accepting and facilitating market will move in either direction with limited volatility in overnight rates will necessitate OIS market to take a closer call on liquidity. This is likely to keep OIS market volatile.
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