Sixth Bi-Monthly Monetary Policy Statement on February 2, 2016 by Governor Rajan: No surprises

But will the current stance of monetary accommodation be able to withstand a China shock?

 Monetary Policy                                                                                                     2015-16

Please read my blog of December 11, 2015.

The last monetary policy statement for 2015-16 contained no surprises: all key rates are on hold.

As I had indicated in my December blog a further easing in the repo rate could be expected only next financial year, if inflation follows the projected trajectory of the RBI – 5% by March 2017.

Loans based on the marginal cost of bank funds will come into effect from April 1, 2016.It will be interesting to see whether this induces banks to pass on more of the 1.25% reduction in the repo rate by the RBI.

Last month saw fresh turbulence in the financial markets, with China at the epicentre of it as its stock markets declined sharply, its currency depreciated, fx reserves fell by more than $ 100 billion, and importantly its regulators lost some credibility in managing markets. India’s economy withstood the turbulence fairly solidly. The SENSEX fell, the rupee weakened against the U.S. dollar but was stable against a basket of currencies, fx reserves fell marginally in January and have since risen, and some money market and bond market rates saw an upward tendency.

India’s superior performance relative to most other emerging markets over the last one year rests on both the government and the RBI taking positive policy and administrative measures. It will be interesting to see what positive surprises government unveils in its next budget due in less than two weeks.

The government is committed to fiscal consolidation, i.e. keeping government spending under control. There have been suggestions in some quarters that government perhaps should go a little easy on fiscal consolidation, and thereby give a boost to the economy to counterbalance the still weak private sector investment. The RBI’s desire as articulated in the monetary policy statement is clear: it prefers the government to undertake structural reforms rather than increase government spending that pushes back the country’s fiscal consolidation target.

China is a source of turbulence in the global economy. The economy has seen a hard landing - how else can one characterise an economy whose growth has halved from heady levels well in excess of 10%?   But a shock would be another matter.

A China shock could come from various sources: excessive debt, troubled banks, a sharp devaluation of the yuan.  This would be a stern test for the RBI’s current course of monetary easing as contagion takes effect. The RBI may then be forced to abandon its current monetary policy stance as it fights stress in multiple markets such as fx and money.