RBI surprises with status quo, but changes stance to hawkish

In a surprise move, the Reserve Bank of India’s (RBI) monetary policy committee (MPC) announced on Friday that it would keep the benchmark lending rate unchanged at 6.5%, despite a broad consensus across the markets that a 25 bps rate hike was on the cards given the recent currency depreciation.

Addressing the media after the rate decision was announced, RBI Governor Urjit Patel said the MPC voted five to one, to leave the repo rate untouched. The RBI however has changed its stance from neutral to “calibrated tightening”.

This, Patel said, means that a rate cut is no longer on the table. “Going forward there are only two options, either we increase rates or we keep them steady. With a neutral stance a cut was also on the table,” he said.

Commenting on the weakening rupee – which fell below the 74 mark against the dollar post the credit policy announcement, Patel asserted that the RBI’s position has always been to ensure that the “forex market remains liquid with no undue volatility.” He added that there is no target of band around any particular level of the exchange rate.

“The depreciation of the rupee has, in some respects, been moderate when compared to several other [emerging market] peers,” said Patel.

On the IL&FS case, which resulted in a contagion that gripped the financials space, Patel commended the government’s intervention, calling the move to set up a new board a “well structured institutional measure” and “timely and appropriate”. He also ensured that the RBI will work with the new management going forward as and when necessary.

Deputy governor N.S. Vishwanathan said that the RBI is closely monitoring the NBFC sector in the wake of the anxiety that has gripped the space. “Last couple of years saw rapid growth in the NBFC sector, NBFCs used diverse source of funds for this expansion… Some of them have resorted to increased market borrowing in terms of [commercial paper], that could result in asset liability mismatch especially for those financing long term assets like infrastructure,” he said, adding that the RBI is looking at strengthening the NBFCs so as to avoid these rollover risks going forward and that the RBI believes that isolated incidents should not have system-wide implications.

Meanwhile,Viral Acharya, deputy governor, RBI assured that the central bank will continue to manage the system liquidity and meet the economy’s demand. In the wake of the contagion in the financials space, Acharya said that the RBI along with the government and SEBI have been closely monitoring the situation. He urged financial firms to place greater reliance on equity and other modes of long-term financing for funding of long-term assets rather than relying excessively on short-term wholesale paper. “Chasing lower marginal costs of funding in order to acquire market share in lending is a myopic strategy; it is associated with significant rollover risks in the medium term and this practice appears to have led to a form of maturity rat race in the financing of the fin sector. Increasing asset liability mismatch in this manner can be a particularly imprudent strategy in times of global and domestic tightening conditions,” he said.

The RBI lowered its inflation projection for the second half of FY19 to 3.9-4.5% from the earlier 4.8%. Retail inflation for the first quarter of FY20, which was earlier seen at 5% is now projected at 4.8%.

Going forward, however, Patel warned of risks to the upside in the form of higher crude oil prices and an escalation in the tariff war. The RBI also reiterated its commitment to the medium-term headline inflation target of 4% on a durable basis.

On the growth front, the RBI retained its FY19 GDP growth forecast of 7.4%, but marginally lowered its projection for Q1 FY20 from 7.5% to 7.4%. Patel struck a positive note for investment activity going forward. “Private consumption will likely be sustained despite the recent rise in oil prices… Improving capacity utilisation, larger FDI inflows and increased financial resources to the corporate sector is projected to augur well for investment activity,” he said.

He however warned that a fiscal slippage on the centre or state level will not bode well for the economy. “Should there be a fiscal slippage at centre or states, it will have a bearing on the inflation outlook, besides heightening market volatility and crowding out private investment,” the RBI governor said.

Patel also outlined a set of measures to be taken to strengthen the economy and make it more resilient to global headwinds which included maintaining the inflation credibility of the monetary policy, sticking to fiscal policy targets, allowing flexible exchange rate adjustment without undue volatility, retaining adequate capital and liquidity buffers in the financial sector to maintain stability and undertaking further structural reforms.

Several experts were taken by surprise by the RBI’s move to keep rates unchanged. Abheek Barua, Chief Economist, HDFC Bank said, “This is a risky move by the RBI since the market was positioned for a rate hike, purely as a rupee defence. In its absence currency and asset markets could see sharper corrections.”

Madhavi Arora, Economist, FX & Rates at Edelweiss Securities said, “While the debt market has rallied on account of the policy surprise, the FX market has been clearly negatively hit. The RBI is clearly of the view that they should let underlying trade competitiveness improve gradually as the trade-weighted exchange rate acts as a natural stabiliser.”

Kumaresh Ramakrishnan, head-fixed income at DHFL Pramerica Mutual fund said, “Near term uncertainties in our view persist from the recent run up in crude prices, a weakening rupee, globally tightening liquidity conditions and some challenges in meeting the fiscal deficit target for the year,” adding that he expects one to two more rate hikes in the current rate cycle.