Demonetization may shrink India’s monetary base, likely to dent demand in months ahead, says Scotiabank

Due to concerns regarding Trmpflation risk, foreign investors have reduced their holdings in Indian bonds, offloading new USD 2.06 billion on 11-18 November, noted Scotiabank in a research report. During the same period, global funds pulled USD 1.08 billion out of embattled bond markets in Indonesia, USD 250 million from South Korea and USD 2.19 billion from Thailand.

While sovereign bond yields have increased throughout the world, India’s government funding costs have dropped. This might be due to the demonetization move in India that has injected additional rupee liquidity to the banking system. This helps steady India’s bond markets and smoothen the rupee exchange rate, said Scotiabank.

India’s Prime Minister Narendra Modi said on Sunday that the demonetization drive would push commercial banks to lower lending rates considerably. The State Bank of India cut rates on deposits from one year to 455 days by 15 basis points to 6.9 percent. This hints that lending rates are expected to follow suit in a few weeks.

Meanwhile, the plan of demonetization might contract India’s monetary base to a certain degree as some old notes might not be exchanged. This has led to cash chaos and is expected to hurt demand and lower CPI inflation in the months ahead, according to Scotiabank. In October, India’s retail inflation slowed a bit to 4.2 percent from September’s 4.31 percent, giving scope for the central bank to lower its policy rate in the coming months. India’s benign inflation outlook would be able to curb increases in the INR REER and result in potential increases in the INR later.

The timing and size of further rate cuts by the Reserve Bank of India are mainly determined by the country’s inflation path. But likely declines in lending rates without a reduction in policy rate would give the RBI time to examine the effect of a Donald Trump administration. Moreover, the Indian central bank might trim its policy rate in December.

“In our view, lower lending rates and resilient dollar strength may postpone a RBI rate cut to Q1 2017”, said Scotiabank.