Mumbai: The Reserve Bank of India (RBI) on Tuesday moved to improve the transmission of interest rate cuts through the system by promising easier liquidity conditions even as it cut its benchmark rate by an additional 25 basis points (bps).

RBI has now cut rates by 150 bps since last January, only about half of which has been passed on by banks through lending rate cuts.

To push the banks further, RBI said that it would maintain “neutral" liquidity as compared to a deficit of 1% of deposits that it was trying to maintain until now. This will happen over the course of the year, the central bank indicated.

RBI will “continue to provide liquidity as required but progressively lower the average ex-ante liquidity deficit in the system from 1% of NDTL (net demand and time liabilities) to a position closer to neutrality," it said while adding that it would smooth the supply of liquidity over the year.

The central bank backed its actions with words and announced an open market operation (OMO) through which it will infuse ₹ 15,000 crore into the system this week. The cash deficit in the system has been close to ₹ 2 trillion in recent weeks but part of this is due to year-end factors like advance tax payments. An increase in the cash in circulation, possibly due to state elections, has also pushed up the deficit.

“Given the various measures that have been taken to fix the policy rate at close to repo rate through these overnight instruments, there is no longer a need to maintain liquidity at deficit," said RBI governor Raghuram Rajan in his post-policy interaction with reporters on Tuesday.

While improving liquidity was the focus of this monetary policy, RBI also announced another cut in its benchmark repo rate. This now stands at 6.5%. The cash reserve ratio (CRR) which the banks maintain remains unchanged at 4%, although banks have been given some leeway to maintain the daily balance of CRR at 90% compared to 95% earlier. This gives lenders some flexibility in managing liquidity.

“The stance of monetary policy will remain accommodative. The Reserve Bank will continue to watch macroeconomic and financial developments in the months ahead with a view to responding with further policy action as space opens up," said the RBI.

RBI also reduced the band between the repo rate and the reverse repo rate to 50 bps from the current 100bps.

While most market participants had expected some liquidity measures, a complete shift in the liquidity stance comes as a positive surprise and will help bring down rates in the system over time.

“I am very happy. We should not worry about the short-term reaction in the market. The RBI intends to bring liquidity into neutrality and I think it would happen sooner than the market expects," said Ananth Narayan G., managing director and regional head for financial markets - ASEAN and South Asia at Standard Chartered Bank.

RBI conceded that short-term liquidity provided through the central bank’s various repo windows cannot address the need for durable liquidity—an argument that bankers have made for some time now. Rajan added that the central bank will now make a clear distinction between durable liquidity and short-term liquidity.

The move to the neutral level of liquidity, however, will not be immediate but will happen over a period of one-two years. “We are not talking quarters. We are talking a year or two," Rajan said.

Narayan expects bond yields to fall by 25 bps over the next few month once RBI begins injecting long-term liquidity. Short-term yields are also likely to fall sharply by at least 30 bps, he said.

“They have already announced an OMO. This gives you some sense how soon they intend to start chipping away at the permanent liquidity deficit," said a senior banker at a foreign bank requesting anonymity.

The shift in liquidity stance will help banks lower their lending rates and thus transmit the policy rate cuts to industry, Rajan said. The central bank noted that the new regime of marginal cost of funds based lending rates (MCLR), along with the lower rates on small savings announced by the government last month, will help in improved transmission of its rate cuts, including those announced last year.

“The reduction in small savings rates announced in March 2016, the substantial refinements in the liquidity management framework announced in this policy review and the introduction of the marginal cost of funds based lending rate (MCLR) should improve transmission and magnify the effects of the current policy rate cut," said the RBI’s policy statement while adding that it is more important at this juncture to ensure that current and past policy rate cuts convert into lower lending rates.

Rajan said that the MCLR has itself brought down rates by 25-50 bps. “Don’t look at it as a 25 bps (cut), look at it as a composite measure," he said while explaining the policy decision.

In response, bankers suggested that rates may ease but over time.

“Liquidity conditions will be helped due to RBI’s measures on cash reserve ratio, lower repo rate, lower SLR and open market operations. All of these indicate a time ahead for softer rates. As far as transmission goes, this particular reduction in rates has been more or less factored in while calculating MCLR. We have to wait and see how these reductions play out and what the eventual lending rate will look like," said V.G. Kannan, managing director and group executive of associates and subsidiaries at State Bank of India.

Most market participants had expected the central bank to cut rates as shown by a Mint poll where 10 out of 11 economists polled had forecast a 25 bps rate cut. Finance minister Arun Jaitley on Monday had also expressed hope that the decision to stick to a fiscal deficit of 3.5% of gross domestic product (GDP) for the current year will help RBI cut rates. “The movement in the last one year, as far as the interest rates have been concerned, has been downwards. The government has stuck to fiscal deficit commitments and inflation has been under control and therefore, I do hope that this movement will continue in order to make our economy more competitive with more competitive interest rates," Jaitley said. The government has also announced a cut in interest rates on its small savings schemes in the range of 40-130 bps.

Inflation and growth

RBI reiterated that inflation is expected to be around 5% for most part of fiscal 2017 and retained its target of 5% consumer price inflation by March 2017.

RBI intends to bring down headline inflation to 4.2% by fiscal 2018, according to the RBI’s Monetary Policy Report that accompanied the policy statement. However, both the projections do not factor in the upside to inflation from wage hikes under Seventh Pay Commission recommendations.

Retail inflation has been easing and touched a four-month low of 5.18% in February. Most analysts expect inflation to ease further in fiscal 2017 contingent upon a normal monsoon. The recent rebound in global commodity prices may pose some upside risks to domestic inflation.

“Inflation has evolved along the projected trajectory and the target set for January 2016 was met with a marginal undershoot. Going forward, CPI inflation is expected to decelerate modestly and remain around 5% during 2016-17," said the RBI in its statement.

RBI’s accompanying monetary policy report stated that a normal monsoon and further fiscal consolidation in line with the path set out by the government could bring inflation down to 4.2% by the fourth quarter of fiscal 2017-18.

“The implementation of one-rank-one-pension (OROP) for retired defence employees and the 7th Central Pay Commission (CPC) award, particularly with regard to house rent allowances, poses upward risks to the baseline inflation path, especially as state governments also start implementation," the RBI, however, cautioned.

The outlook on growth remains mired in uncertainties even though the central bank retained its growth forecast for the year at 7.6%.

“The uneven recovery in growth in 2015-16 is likely to strengthen gradually into 2016-17, assuming a normal monsoon, the likely boost to consumption demand from the implementation of the 7th Pay Commission recommendations and OROP, and continuing monetary policy accommodation," RBI said.

The monetary policy report highlighted a number of factors that could weigh on growth this year. These range from debt-heavy balance sheets of the corporate sector and low capacity utilization. Some of these pressures may get balanced out by stronger consumption demand.

“A number of factors could impinge upon the growth outlook for 2016-17. First, slow investment recovery amidst balance sheet adjustments of corporates is likely to hinder investment demand. Secondly, with capacity utilisation in the organised industrial sector estimated at 72.5 percent, revival of private investment is expected to be hesitant. Thirdly, global output and trade growth remain tepid, dragging down net exports," said the central bank in its monetary policy report.

The government’s “start-up" initiative, strong commitment to fiscal targets, and the thrust on boosting infrastructure could brighten the investment climate, RBI added while also suggesting that consumption demand could benefit from pay commission payouts, past interest rate cuts and government measures to boost the rural economy.

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