March 2015

CRISIL Monetary Policy Review

RBI acting while it can
Another pleasant surprise for the street! The Reserve Bank of India (RBI) on Wednesday reduced the policy rate by 25 basis points
(bps), bringing the repo rate down to 7.5%. The move could nudge banks to move faster on cutting lending rates and give them more
comfort on the future trajectory of policy rates.
The apex bank justified the latest action coming in before the next bi-monthly meeting on April 7 as anticipatory, since the current
environment suggests room for an easing monetary policy stance. The reduction comes on the backdrop of three factors: 1) February
inflation data (at 5.1%) was well within the central banks target, 2) the Union budget affirmed commitment to improving the quality of
fiscal adjustment and budgetary measures expected to improve the supply situation over the medium run, and 3) the agreement
between the government and the RBI on a new monetary policy framework entailing guidance on how this mandate will be
implemented by the RBI.
Going ahead, we expect the RBI to deliver rate cuts to the tune of 50 basis points (bps) next fiscal with a high likelihood
they would be frontloaded. On inflation, we expect the Consumer Price Index (CPI) to average 5.8% - below the central
banks target of 6% for FY16.
The budget has been non-inflationary. However, we believe that achieving the target of 4% beyond FY16 is still a tall order and
requires structural changes in the food supply chain to tie down food inflation sustainably. Also, risks to the 6% target for FY16 are
present although weak at the moment.

What and why of the RBI action

Inflation has been trending down, creating room for lower rates: The new CPI series for February showed inflation at 5.1%,
with benign trends in vegetable prices, fuel and core inflation. This signals the downward trend in inflation is unfolding faster
than envisioned. On the growth front, a few days back, The Economic Survey had categorised the Indian economy as recovering
and surging. The new GDP series, too, presents a rosy picture, though short-term indicators such as capacity utilisation and
credit are at odds with it. Understandably, the economy is operating below its potential.

Monetary policy framework brings clarity and gives definitive direction on interest rates: The government and the RBI
agreed on a monetary policy framework to bring down inflation below 6% by FY16 and to 4% with a band of +/-2% in subsequent
years. With current inflation much below this target, the RBI has space to bring down the policy rate. Also, adoption of the new
framework will help curb volatility in inflation expectations by making monetary policy more transparent and predictable.
The RBI statement on Wednesday highlighted that further action will depend on incoming data, easing supply constraints,
continuing progress on fiscal consolidation, pass through of rate cuts, monsoons and the international environment. We believe
these factors will be conducive for a further easing of 50 bps next fiscal.

Quality of fiscal adjustment in the budget is favourable to inflation: Union budget 2015-16 postponed the target of 3% for
fiscal deficit by a year. However, realism in its projections on revenue, measures to improve manufacturing and ease of doing
business, shift of focus from subsidies to spending on infrastructure and providing greater freedom to states with higher

CRISIL Monetary Policy Review

devolution are all positive steps that will improve the quality of the fiscal adjustment underway. This will result in raising supply
and potential in the economy. To this extent, the budget is non-inflationary. This opens room for easing.

Risks remain: We caution against certain risks in the current environment that might restrict monetary policy decisions: 1) the
fiscal target for FY16 at 3.9% is dependent on oil prices remaining range-bound up to 70$/bbl. An increase in oil prices beyond
this level and in the subsidy bill could reduce capital expenditure and compromise the quality of fiscal consolidation laid out. 2)
Volatility in food inflation due to weather related factors might raise overall inflation. In such a scenario, the government will need
to take strict measures to rein in food inflation in order to meet the inflation target.

Transmission to play a key role

The transmission of lower policy rates to lower lending rates and eventually growth will be a slow process, given high non-performing
assets (NPAs) at banks and downward rigidity in lending rates. With the RBI kicking off an easing cycle, focus has shifted to how fast
interest rate cuts can stoke the economy. Transmission is first felt on deposit and lending rates and then on growth. But this time
around, deposit and lending rates will be slow to respond, which will make the overall transmission process a sluggish one.
Banks had started to reduce deposit rates by about 25-50 basis points starting October 2014 due to ample liquidity in the system, but
have been reluctant to cut down their lending rates so far, given the sluggish growth in interest income and risk aversion.
Consequently, we expect base rates to come down towards the end of this fiscal, though not in the same magnitude as the rate cuts.
The future transmission of policy rate cuts beyond the near term, though, will hinge on the extent of risk aversion amongst banks
which currently remains elevated due to the high level of non-performing assets.

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