The Reserve Bank of India (RBI) in its second bi-monthly review for this fiscal maintained status quo on the repo rate. The repo rate, reverse repo rate, and marginal standing facility rate continue to stand at 6.5%, 6.0%, and 7.0%, respectively. This is in line with India Ratings and Research's (Ind-Ra) expectation. RBI also kept the cash reserve ratio at 4% in line with Ind-Ra's expectations.

Ind-Ra believes RBI had front-loaded the rate cut in the month of April 2016 on the expectation of a normal monsoon and declining retail inflation. Although the expectation of a normal monsoon has gained further strength post the latest assessment by Indian Meteorological Department, so have the pressure points with respect to inflation. These are (i) firming up of global oil prices and (ii) the impact of implementation of the award of Seventh Pay Commission. Therefore, Ind-Ra believes keeping the policy rates unchanged at this juncture is a prudent step. Ind-Ra believes RBI still has room to ease policy rates by another 25bp this fiscal but it will be contingent on the outturn of monsoon and its subsequent impact on inflation along with crude price movement and global risk balance.

Upward Bias in Inflation Trajectory: For RBI, the transmission of the previous rate cuts remains a 'work-in-progress' and it sees some uncertainties surrounding the domestic inflation trajectory. Yet RBI has retained its Consumer Price Inflation projection at the level of around 5% during FY17, which is same as stated in the April 2016 policy statement. The forward stance of RBI however crucially hinges on the evolving inflation trajectory amid continued global uncertainties. Inflation surprised on the upside in April 2016. Consumer Price Index increased to 5.4% in April 2016 led by food prices. On the domestic front, the behaviour of food inflation and the ability of the manufacturing sector to exercise pricing power over the coming months will determine the inflation trajectory. However on both accounts, the outlooks appear favourable. According to Indian Meteorological Department's revised forecast, rainfall will be above normal and well distributed (spatial and temporal) this year.

In addition, the existence of excess capacity in the manufacturing sector will keep a check on output prices even as demand picks up.

Growth Momentum Visible: According to RBI's assessment, domestic conditions for growth are improving gradually, mainly driven by consumption demand. Rural demand is likely to pick-up pace aided by a normal monsoon while rising consumer confidence, combined with the implementation of Pay Commission award, will likely boost the overall consumer spending. The central bank's latest rounds of forward-looking surveys indicate an improvement in the business situation, driven by a pick-up in capacity utilisation and order books. Private investment, though, remains weak due to financial stress. However, public investment, mainly in roads and railways, is gaining strength and is likely to give a fillip to private investment. Despite the signs of improving business conditions, RBI expects business confidence will remain curbed on account of external factors such as slowdown in global economic activity, geo-political events with consequent impact on financial flows, and muted trade on weak demand. The central bank has retained its projection of gross valued added for FY17 at 7.6% based on its assessment of risks from domestic and global factors.

Policy to Have Neutral Impact on Bond Market: In the near term, the bond market is likely to look through today's policy as a reiteration of RBI's stated intent of staying accommodative and providing adequate liquidity - resulting in curve steepening. The focus will be on high volatility global developments such as the upcoming US Fed policy review (14-15 June 2016) as also the Brexit vote decision. The bond market is likely to remain focussed on the scope for incremental open market operations in the coming days. RBI has made an open market purchase of INR0.70trn in the last two months. While the short-term possibility of bond yields moving up remain, Ind-Ra remains constructive on the bond market for the medium term based on two developments - favourable demand & supply dynamics and easy liquidity. Ind-Ra expects the overall focus of market to shift to these two developments, once the uncertainties related to the Fed's action and concerns over monsoon alleviate.

Rupee to Remain Stable, Notwithstanding FCNR B Redemptions: Ind-Ra had already outlined that the foreign currency non-resident bank account FCNR (B) deposit redemption risks were manageable, which RBI emphasised today. RBI is actively deploying a communication channel to discourage any possible episodes of currency speculation as also alleviate excessive concerns building up around the redemption pressure. In Ind-Ra's assessment, RBI's proactive cognizance of redemption pressure as also willingness to utilise foreign exchange reserves, if need be, will ensure rupee stability when the bunched up redemptions fall due. At the same time, RBI's management of rupee liquidity in the period can be through multiple tools - longer tenor term repos, durable infusion through open market operation purchases of G-sec and relaxation in the daily requirement for cash reserve ratio (currently at 90%), ensuring the transition into a neutral liquidity position. The rupee is likely to continue taking cues from the shifts in global risk preference and stay relatively stable ahead of the Fed policy outcome.

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