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Indian central bank cuts growth forecast to 7.1%

Wary of impact of demonetization, RBI surprises by holding policy rate steady

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People walk past the Reserve Bank of India head office in Mumbai.   © Reuters

MUMBAI/NEW DELHI -- In its first monetary policy review since the shock demonetization of high-denomination bank notes a month ago, India's central bank on Wednesday kept the benchmark interest rate unchanged at 6.25% and slashed its economic growth forecast for the current fiscal year to 7.1% from 7.6%, citing short-term disruptions in economic activity and demand compression.

Ahead of the announcement, many expected the Reserve Bank of India's Monetary Policy Committee, led by Gov. Urjit Patel, to lower the repo rate -- or key lending rate -- by 25 basis points, given the post-demonetization cash crunch that threatens to impede the growth of the world's fastest growing major economy.

This was the RBI's first policy review since Prime Minister Narendra Modi stunned the nation on Nov. 8 by announcing a ban on 500- and 1,000-rupee bank notes. The move -- part of a crackdown on black money, or unaccounted-for wealth -- rendered unusable 86% of the money in circulation by value, precipitating a liquidity crunch in the cash-heavy economy.

Rationale behind status quo

The RBI said all six committee members voted to keep the rate unchanged, citing their concern about "heightened uncertainty" due to external factors. 

"Globally, the imminent tightening of monetary policy in the U.S. is triggering bouts of high volatility in financial markets, with the possibility of large spillovers that could have macroeconomic implications for EMEs [emerging market economies]," the central bank said in a statement.

The RBI appears to be waiting for the dust to settle in the wake of the currency ban before making any big moves. It noted that post-demonetization supply disruptions may drag down growth this year, but added that the situation needs to be analyzed more carefully before drawing any conclusions about the full effects and length of those disruptions.

The central bank said short-term developments that have an outsize influence on the outlook warrant caution when setting the monetary policy stance. "If the impact is transient, as widely expected, growth should rebound strongly," said the RBI, which cut its gross value-added growth forecast for the current financial year ending March 2017 by 50 basis points to 7.1%.

Patel told a press conference that the committee felt it was important to achieve the inflation targets of 5% for the last quarter of the current fiscal year and 4% -- plus or minus 2% -- for the medium term. "This assumes critical importance in view of the stickiness in inflation, excluding food and fuel."

London-based research consultancy Capital Economics commented that it was not expecting rates to stay put. "Having previously shown that it was willing to prioritize growth even at the risk of missing targets for inflation, the RBI's decision today to keep interest rates on hold despite the downside risks created by demonetization comes as a surprise," it said.

RBI on currency ban

Patel said the demonetization decision was "not taken in haste but after detailed deliberations." He said the central bank and the government were aware the move would create difficulties for the public at large, and that "all dispensations were put into place to ensure that the period for disruption is the minimal."

The RBI said 11.55 trillion rupees ($170.9 billion) worth of banned notes have been deposited in banks since the demonetization move. People can deposit the notes into their bank accounts until Dec. 30.

A recent report by the State Bank of India says that excluding money already in banks, 15.4 trillion rupees worth of high-denomination notes were in circulation as of Nov. 9.

Meanwhile, the RBI on Wednesday gave a boost to banks by announcing that from Dec. 10, it was ending the 100% incremental cash reserve ratio requirement imposed after demonetization as part of a liquidity management operation to handle the return of the banned notes into the system. The move will lend liquidity to the market, said Kuntal Sur, partner at PwC India.

The rupee has taken a bit of a hit from the rate decision. After the announcement at 2:30 p.m., local time, the Indian currency was trading at 67.94 against the dollar, down from the previous close of 67.90. The BSE Sensex ended at 26,236.87, down about 156 points, or 0.6%.

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