RBI stated policy stance is calibrated tightening and it was kept the same in today’s policy review, though one member of the MPC voted to change the stance to neutral. The policy stance is calibrated tightening but with inflation projections revised down and GDP growth rate kept flat, the need for calibrated tightening does not arise.
RBI has pumped in Rs 1360 billion of primary liquidity into the system through OMO bond purchases and is planning to add Rs 400 billion more in December 2018. The liquidity infusion by the RBI is to lower system liquidity, which has been in negative since the last six months on the back of multiple factors including RBI fx sales, rising ICDR (Incremental Credit Deposit Ratio) and rise in currency in circulation. RBI has sold fx worth over Rs 1200 billion as the INR depreciated to all time lows on capital outflows. ICDR is at levels of 114% as credit growth has been well abover deposit growth. Currency in Circulation has risen by Rs 1800 billion this fiscal year so far on demonetization effects wearing off on currency supply.
Given the fact that a repo rate hike is not expected in the near future and that RBI is buying bonds, even as the government is borrowing less, bond short supply will drive down yields in the near term. However, looming general elections in May 2019 and budget in February 2019, bond yield rally will be capped,
10 year benchmark government bond yield is unlikely to trend too much below 7.5%. OIS yield curve will stay flat on lack of rate hike expectations.
INR is likely to stabilize at around Rs 70 to the USD on the back of sharp fall in oil prices and improved FII flows that turned positive in November after many months of being negative. Global growth is showing signs of slowing down on trade war issues while the Fed is now turning uncertain on rate hikes in 2019, which will keep the USD from strengthening. US treasury yields have also dipped by over 20bps from highs on growth worries.
RBI has cut SLR to bring it in line with the LCR. This will not have much of an impact on yields as banks are still well above SLR limits of 19.5%.
The issue facing the RBI is the credit markets that have almost frozen since IL&FS default in September 2018. RBI has announced a series of measures to alleviate the liquidity freeze (Read our report on RBI measures), but there is still risk aversion in the markets. Given that NBFCs may slowdown lending in the face of liquidity crunch, consumption may not be robust and that can pull down growth optimism.
There has definitely been a slowdown in sectors such as auto and agricultural machinery but indicators such as bank credit growth, which is at multiyear highs, rising investments on government spending and an almost closed output gap (according to the RBI) suggests that growth risks are evenly balanced.