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RBI redeems itself...? - Outside View by Arvind Chari
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RBI redeems itself...?
Dec 10, 2016

In a surprise move, the Monetary policy committee (MPC) of the Reserve Bank of India, decided to not cut the repo rate and hold it steady at 6.25%.

The decision was unanimous. The MPC voted 6-0 to keep the rates on hold. The second MPC meeting and the second 6-0 vote.

It was a complete non-consensus move, as almost everyone in the street expected atleast a 25 bps cut if not a 50 bps cut.

The no change did shock the street. It shows the difference in the views of the RBI and the market.

Since the entire demonetization drama unfolded, there have been numerous questions being asked of the RBI.

Be it over the silence of Dr. Urjit Patel, the governor of the RBI, on the impact of demonetization, or on the role of government over RBI.

It has been plain and visible that the government has been at the center stage of the entire Demonetization issue, an issue which technically pertains to the central bank of the country. The government seemed to be framing all the rules and the RBI was just implementing and following it.

There were questions being raised on RBI's independence and objectivity. There was even a cartoon lampooning the RBI governor in a leading daily.

The situation was not comfortable. RBIs 'de-facto' independence and objectivity is at a risk as we pointed out in our previous update on demonetization. The RBI and the RBI governor have always maintained and displayed their independence and it remains the most crucial thing for investor confidence.

With this non-consensus move of holding rates steady, we do believe the RBI has made a big statement towards its independence and objectivity.

The RBI has very rightly chosen to ignore market expectations of large rate cuts and has opted to wait and watch the actual potential impact of demonetization on India's inflation and growth.

"In the view of the Committee, this bi-monthly review is set against the backdrop of heightened uncertainty. Globally, the imminent tightening of monetary policy in the US is triggering bouts of high volatility in financial markets, with the possibility of large spillovers that could have macroeconomic implications for EMEs. In India, while supply disruptions in the backwash of currency replacement may drag down growth this year, it is important to analyse more information and experience before judging their full effects and their persistence - short-term developments that influence the outlook disproportionately warrant caution with respect to setting the monetary policy stance".

"It is appropriate to look through the transitory but unclear effects of the withdrawal of SBNs while setting the monetary policy stance. On balance, therefore, it is prudent to wait and watch how these factors play out and impinge upon the outlook. Accordingly, the policy repo rate has been kept on hold in this review, while retaining an accommodative policy stance".

The RBI by waiting and watching the impact is doing absolutely the right thing. It is also open to completely look through the transient impact of demonetization and focus on the medium term. This is extremely reassuring by the new governor and the newly formed MPC.

The non-consensus move of holding rates steady thus turned out to be a major shock and the bond market reaction clearly showed it.

The 10 year government bond yield went up by 21 bps to end the day at 6.41%. Before the rate cut, the 10 year bond yield traded as low as 6.16% suggesting that the bond markets were expecting more than 25 bps rate cut by the RBI and were clearly disappointed with the outcome.

The No rate cut today though does not mean there are no chances of further rate cuts.

If the effects of demonetization does indeed lead to lower inflation and slower growth, the RBI will look to cut in its February policy review. By February, the RBI will also have greater clarity on the global situation (FED rate hike and Donald Trumps policies), the impact of demonetization and on India's fiscal deficit for Fy 18, which would allow them to take a more balanced view.

We also believe that by holding rates today, the RBI would quell the selling by foreigners in the bond markets. Foreigners have sold USD 3.5bln of Indian government bonds since the start of October and the pace of selling picked up since November 8th as Indian bonds decoupled with the Modi demonitisation 'trumping' the global Donald Trump reflation trade.

The decision to hold seemed to have had the government's veto too. The Chief Economic Advisor to the finance minister said it was a 'bold and a brilliant call' and that it would help stem the rupee volatility due to foreign outflows.

The impact was clearly visible on the Indian rupee, which had depreciated to its lowest level in the last week at 68.86/$, ending the day stronger at 67.60/$.

But given the risks - global bond yields, Trump and the seemingly apparent failure of Modi's demonetization move, we would remain cautious on the INR.

Arvind Chari is Head Fixed Income & Alternatives at Quantum Advisors Pvt Ltd and advises two India dedicated off-shore India fixed income funds. Arvind was previously the fund manager for the Quantum Liquid Fund and the Quantum Equity Fund of Funds at Quantum Asset Management Company Pvt Ltd.


The views expressed in the Article are the personal views of the author, Arvind Chari and not views of Quantum Advisors Private Limited (QAS). QAS may or may not have the same view and does not endorse this view.

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