RBI has to start bond buying soon to infuse durable liquidity
As expected, the RBI left key interest rates unchanged and also maintained its accommodative stance; although, it comes with a bit of caution. It has cautioned on the potential inflationary impact of the 7th Pay Commission as also on the need to be vigilant towards the price rise in some food products. RBI has still maintained its inflation target of around the 5.0% mark in March 2017. The RBI’s inflation target now is 5.0% by Jan-Mar 2017. Given the factors laid above and the impact of increase in service tax in the next budget, it would be a great challenge to meet the 5.0% target. We thus hold our view that the next rate cut (25 bps) would be possible only post the Budget. With the RBI highlighting the impact of Pay Commission on the fiscal numbers, it would want to wait and see the markets’ response to the Government’s ability to meet the 3.5% Fiscal Deficit target. If the market senses that the Budget numbers are credible and the Government has resources to meet the 3.5% target, it would improve investor confidence and the RBI will be able to utilize the limited space available to cut rates to 6.5%. Any reduction in interest rates post that would depend on the RBI achieving the 5.0% inflation target. More than the quantum of rate cuts the RBI should now focus all its energy on improving the transmission. RBI has cut rates by 125 bps since January but total lending rate cuts by banks have been less than 60 bps. For the economy to benefit from the low inflation and monetary accommodation; lending rates have to fall more, and quickly. Even in the bond markets, post the fall seen in 2014 in anticipation of rate cuts; the bond yields haven’t fallen by much as supply outstrips demand. In an accommodative cycle, the liquidity situation has to be remain plentiful for the banks’ cost of funds to fall and which then banks can pass on to the borrowers. Data that we maintain shows us that Core Liquidity (liquidity directly managed by the RBI) which was surplus to the tune of INR 800 bln in August 2015 has turned into a deficit of INR 250 bln in November. RBI needs to ensure that Core Liquidity swings back into surplus so as to ensure that banks can pass on the benefit of lower cost of funds by cutting lending rates. As foreign inflows have dried up, RBI will have to resort to buying Government bonds to infuse durable (long term) liquidity.