The MPC kept repo rate unchanged (4:2 majority) and persisted with the neutral stance, while the RBI cut CRR by 50 bps which was beginning to emerge as the majority expectation post recent liquidity tightness. Forecast changes are summarized below:
Before we turn to the policy nuances and our expectations, we visit briefly the broader framework for macro policy in light of developments since the Covid crisis.
A Framework Discussion
It is well understood that developing markets have tighter thresholds of macro stability parameters than their developed market counterparts. This was in evidence during the Covid response where countries like India had to have a much more nuanced fiscal and monetary response as compared to the US which, admittedly, was the other extreme. Of course, this had also to do with the diagnosis of the sustained economic impact and the extent to which the respective economy was willing to borrow from future generations. The result, however, was that while US was able to recoup all cumulative output lost versus previous trend growth (and then some more), India had to be able to post years of above previous trend growth in order to be able to do so. Thus, a post Covid challenge for fiscal and monetary authorities has been to be able to nurture growth expansion for longer via judicious macro policy that sustains financial stability. One must note that Indian policy makers have been remarkably adept at this. Thus, RBI’s proactive monetary tightening, alongside auto-expiry of Covid liquidity measures, ensured that repo rate could peak at a relatively modest 6.5%. Alongside, regulatory measures have pre-empted any meaningful buildup of financial imbalances. On its part, the government moved to re-orient spending towards capex and consolidate fiscal deficit once the crisis was over.
An additional challenge imposed, however, has been from the continued US exceptionalism. At first the very aggressive Covid fiscal and monetary response led to high US rates and stronger dollar. However, these have largely sustained owing to limited fiscal compression there, accompanied with a productivity and labor supply boost. This set-up naturally curbs the degrees of freedom available for countries like India in the near term, even as our growing resilience will ensure that this is less so over the medium term. Thus, greater prudence is naturally warranted to ensure ongoing financial stability which in turn allows for a consistent runway for growth. At the same time, the sensitivity to a growth slowdown has to be greater given that there is still a cumulative output loss to fill which in turn impacts the economy’s ability to fully absorb the additions to labor supply. As an aside, this same dynamic is probably ensuring that high food inflation has so far not seeped into core. It also means that one cannot worry about demand inflation too much.
Monetary Policy Assessment Under The Above Framework
The framework above throws up three takeaways:
1. Prudent expansion and then normalization of fiscal and monetary policy has allowed countries like India to sustain the post pandemic expansion for longer.
2. The continued US exceptionalism has limited degrees of freedom for policy in the near term.
3. Optimization is nevertheless required within this constraint given the need to fill the cumulative ‘output deficit’.
We use this context to look at the policy today:
No matter how one cuts it, growth is slowing since some of the underlying drivers have visibly slowed. The most obvious example here is of leveraged consumption. Business sentiment, though currently holding, may also take a hit in a heightened tariff world and with China continuing to export away its excess capacity. These are slower moving cycle factors and will take time to reverse even as temporary boosts to growth from better agricultural output and revival in government spending may be forthcoming. To be fair, while its concurrent prognosis remains upbeat, the RBI/ MPC have opened the door to acting to support growth if required. Thus, the Governor’s statement reads: “On the other hand, a growth slowdown – if it lingers beyond a point – may need policy support.” This combined with a Q2 FY26 CPI forecast of 4% gives enough room to start the repo rate cut cycle in February, which remains our base case.
The aspect of liquidity is somewhat more interesting. Core system liquidity has declined by more than INR 3 lakh crores since mid-October with the biggest driver being dollar sales by the RBI. There has also been some rupee security maturity on RBI balance sheet recently. Looking ahead, currency in circulation picks up again from the next quarter and, even assuming a slowing of its growth rate, should deduct another approximately INR 1.25 lakh crores from core liquidity over this period. Furthermore, one cannot budget for much relief on the FX side (rate ceiling hike on FCNR(B) deposits is expected to yield limited impact as per initial feedback given most bank rates were below even the existing ceiling). Given this, while the CRR cut today is helpful, it will still likely fall far short of the actual permanent liquidity infusion required. For that reason, we expect OMO purchases to also begin soon.
Takeaways
As per our understanding of previous RBI communications, the stance informs the likelihood of change in repo rate while liquidity policy should be almost considered automatic: that is, RBI will provide sufficient liquidity deploying temporary (VRR/VRRR) and / or permanent ones (CRR/OMO) as deemed fit. Additional tool is via FX spot or forward operations but these may be constrained basis external circumstances.
The policy today opens a wide door for a February repo rate cut. Growth is slowing notwithstanding a seasonal rebound currently, the Governor has made a hat-tip to the potential need to act if slowdown continues, sensitivity to such a slowdown may be large owing to the context discussed above, and forward inflation forecasts provide the necessary room to act provided the near prints on inflation do nothing to change that forecast.
With respect to liquidity, the following points need noting:
1. The current liquidity tightness is basis fall in core liquidity. This is unlike previous recent instances when core liquidity was heavily in surplus and headline liquidity tightness was owing to fluctuations in government cash balances.
2. This then points to using permanent tools rather than temporary ones used before like variable rate repo operations.
3. The CRR cut today, while helpful in the short term, may not be enough when we consider the period upto 31st March. We estimate core liquidity currently is just about INR 1 lakh crore. Assuming no further forex led creation / destruction in rupee liquidity, and accounting for the seasonal rise in currency in circulation over the next quarter, the RBI may still need to do OMO bond purchases of around 1 lakh crores over the next few months. This will be needed to shore up core liquidity to a base level of surplus that will not cause repeated deficits in headline liquidity owing to government cash balance fluctuations. The quantum of OMOs needed may be even higher if dollar sales continue from the RBI. Also, as the MPC shifts to rate cuts from February, the RBI may need to step up liquidity creation to ensure transmission of cuts.
For investors, the demand-supply equation for SLR securities remains favorable and is expected to become more so as the RBI starts bond purchases. For the corporate bond curve, the elevated front end rates (upto 2 years or so) represent an attractive opportunity which should be capitalised upon during the next few months especially with banks’ credit to deposit already rebalancing notably. We expect the shape of the corporate bond curve to start to normalise (with front end rates falling faster) from April onwards.
Source: RBI and Bandhan internal research
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