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18th Aug 2017 Primary Dealer Ltd Macroeconomic Update: RBI Aug MPC Policy Minutes

Reserve Bank of at the MPC meeting held on Aug 1-2, in 4-2 vote decided to cut the policy rate by 25 basis points to 6% acknowledging the sharp fall in inflation in the April-June period. The two members, namely Dr Ravindra Dholakia and Dr did not favor the reduction, instead raising calls for a 50bps cut and a status quo stance respectively.

However, the minutes of the Aug MPC meeting reveal that reversal of the deflationary trend, sluggish growth, negative output gap and a weak banking sector are concerns that continue to dominate the narrative of policy members. Dr Ravindra Dholakia and RBI executive director Dr Michael Patra are dovish and hawkish, respectively while the other members sounded less optimistic over growth.

Voting for the resolution to reduce policy rate by 25bps to 6%

Members Vote Dr Chetan Ghate Yes Dr Pami Dua Yes Dr Ravindra Dholakia No(50bps cut)

Dr Michael Patra No(Status quo)

Dr Yes Dr Yes

Below is the summary of statements by RBI MPC panel members:

Dr Chetan Ghate acknowleged the significant decline in headline and Core inflation but remained doubtful over the durability of these levels citing that inflation has bottomed out in June and is likely to move higher hereon. With regards to the impact of HRA, he believes that depressed demand conditions in the real estate sector could negate the second-round effects to some extent. Further, farm loan waivers could add to inflationary pressures. However, he pointed out that weak capital accumulation continues to be the the biggest concern owing to weak investment.

Dr Pami Dua reiterated upside risks to inflation going ahead but was also of the view that some upside risks have decreased or not materialised, which have counterbalanced 1

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18th Aug 2017 Primary Dealer Ltd inflationary pressures. These factors include normal monsoon, effective supply management, smooth roll-out of GST and stable commodity prices. She further noted that twin problems of weak capex cycle and debt overhang have supressed investment amidst infrastructure bottlenecks.

Dr Ravindra Dholakia maintained the urgency of a 50bps rate cut as proposed by him at the June policy amidst low inflation, overestimation of the impact of HRA and unlikelihood of fiscal slippages arising from farm loan waivers. He believes that state’s fiscal deficit may not see any risks after accounting for higher revenue bouyancy from both direct and indirect taxes. HRA impact too is seen as transient and staggered. Meanwhile, focus needs to be on the closing the negative output gap and increasing capacity utlisation that has consistently been below 75%. Dholakia not only maintained the need of 50bps cut but also said room to cut rates could further open up contingent on incoming data.

Dr Michael Patra flagged upside risks to inflation in the coming months as favourable base effect wears off from August. The 106% increase in HRA is anticipated to seep into headline inflation numbers starting July and continue till December while uncertainty over the roll-out of GST continues to persist. He maintained his view to keep rates on hold and remain watchful of incoming data as a scenario of high valuations in equity and fixed income, appreciating rupee and liquidity overhang could lead to financial imbalance.

Dr Viral Acharya voted for a 25bps cut while maintaining a neutral stance as supressed growth is rooted in stressed balance-sheets of banks. Focus at this juncture should be to improve the conditions for sound transmission such as healthy bank and corporate balance sheets, market-based benchmarking of bank lending rates and a thriving corporate bond market, he said. He too expressed concern over fiscal slippage due to farm loan waivers that could crowd out private credit through added state borrowings from the market.

Dr Urjit Patel turned attention to sluggish growth in industry and services, despite keeping GVA estimated unchanged at 7.3% for FY18. A neutral stance was adopted as more clarity is needed on whether recent disinflation is structural or temporary. Also, second-order effects of HRA through the implementation of 7 th CPC recommendations by states needs to be closely watched. He once again reiterated that the implementation of farm debt waivers by the State Governments has significantly increased the fiscal risks and poses an upside risk to the inflation outlook. Also, as credit 2

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18th Aug 2017 Primary Dealer Ltd growth continues to remain weak, resolution of banks stressed assets will be a key point of focus.

Forward-looking estimations by MPC members

 The industrial outlook survey and the consumer confidence survey conducted by the RBI suggest that negative output gaps will remain in Q2.  Volatility from Feds "quantitative tightening" is likely to be imparted on EME exchange rates and financial markets.  Growth in the Indian Leading Index (constructed by the Economic Cycle Research Institute (ECRI) is falling, as is Indian Leading Exports Index growth.  With minor spikes, expect core inflation reaching around 3.1-3.5% by March 2018.  Impact of HRA is likely to remain transient and could be seen over the course of 18-24 months as states begin its implementation.

Conclusion : The MPC panel at the Aug policy not only continued to highlight upside risks to inflation but also shifted its focus towards tepid growth and fiscal pressures arising from farm loan waivers.

The strongest voices were of the two dissenting and opposing votes. Dr Patra’s hawkish view of rising inflation seems to be falling in place after CPI for the month of July rose 90 bps to 2.36% from record low 1.46% seen in June.

Going ahead, we believe inflation is set to reverse its downward trend as a favourable base-effect wears off from August onwards and prices of food items continue to accelerate, albeit at a slower pace than that seen in July. However, from here on factors including the impact of HRA under 7 th CPC recommendations and GST could play a vital role in headline readings. We expect inflation to inch above 4% in the Jan-Mar 2018 period due to these factors. However, this could still mean that overall headline inflation for the fiscal year 2017-18 could remain below the RBI’s 4% target at 3.5-3.6%.

Chances of further monetary policy easing at the next policy are completely negated owing to the dim outlook on inflation projected by all the MPC panel members. However, we believe room could open up for another 25bps rate cut, possibly in Q4FY18, contingent on any adverse external shocks arising from exchange rate volatility,

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18th Aug 2017 Primary Dealer Ltd Federal Reserve’s stance on interest rates and balance-sheet reduction and crude oil prices.

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