Commercial banks as well as Indian corporations do not want the country’s central bank to go for yet another rate hike, the 11th since March 2010, when it unveils the quarterly review of monetary policy on Tuesday, but the Reserve Bank of India (RBI) is unlikely to oblige them. My guess is RBI governor D. Subbarao will once again take his now-famous baby step and hike the policy rate by 25 basis points (bps) to 7.75%, raising it by 450 bps in the current rate tightening cycle.
One basis point is one-hundredth of a percentage point.
Bankers do not want RBI to raise rates as a higher policy rate makes money more expensive and affects the growth of the loan book. If corporations and individuals go slow in borrowing money from banks because of high costs, their interest income goes down. Besides, loans given at a high rate also run the risk of turning bad as borrowers may fail to repay. In that case, banks need to set aside money, or provide for bad assets, and that dents their profitability. Corporations, too, do not want any more rate hikes for the same set of reasons. When the cost of money goes up, their capacity to borrow gets affected and they prefer to go slow on investment plans.
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Even some economists are arguing against another rate hike. They feel that inflation is under control (even after the latest hike in petrol and diesel prices, inflation has not risen to double digits) and the impact of RBI’s past rate hikes is being seen. Besides, by making money more expensive, the central bank is forcing corporations to shelve investment decisions. In the absence of fresh investments, supply-side problems will continue to haunt the economy and inflation will not come down. In other words, RBI’s action of rate hike to contain inflation is self-defeating.
The last time the Indian central bank raised its policy rate was in June. Let’s take a look at what all has changed since then. The growth in factory output has been moderating—5.8% year-on-year in April and further down to 5.6% in May. The HSBC Purchasing Managers’ Index (PMI) for manufacturing also confirms that the Indian economy is seeing a moderation in the pace of growth, but the deceleration is not dramatic as yet. The banking industry’s loan growth has been slowing. After growing at 22% in last fiscal, the loan growth now has come down to 19.9%.
Yet another leading indicator of a slowing economy is the drop in car sales. After growing at close to 30% last year, car sales growth dropped to 7.3% in the first three months of the current fiscal. Particularly in June, it dropped to 1.6%, lowest since March 2009. Commercial vehicles sales growth, too, dropped to about 14% in the first quarter against about 27% last year. In June, commercial vehicles growth was close to 18%.
Global commodity prices, particularly crude oil, softened between April and the first half of June, but have risen since then; and uncertainties surrounding the recovery of the US and the euro zone have intensified.
If these are reasons to press the pause button, the compulsion to go for another rate hike is equally strong—persistently high inflation. The provisional figure for wholesale price inflation was 9.44% in June and it will probably rise further once it is revised. Food prices in the first week of July rose at their slowest pace in 27 months. While that’s good news, the bad news is that non-food manufacturing inflation, a proxy for core inflation, continues to remain high. In June it was 7.2%, marginally lower than 7.3% in May. Rising interest rates and commodity prices have started hurting profitability at Indian firms, but sales growth in the June quarter remains robust. This means the consumption story in the world’s second fastest growing major economy remains intact.
It’s given that RBI will hike the key rate, but the real challenge for the central bank will be its communication on the outlook on interest rates. Is it coming close to the end of the rate tightening cycle? If indeed this is the case, will it tell the market so? With signs of deceleration slowly gathering momentum and core inflation remaining stable, there may not be too many rate hikes in the coming months. The pace of hike will probably also slow.
In May, RBI had said its efforts would be to sustain the growth “in the medium term by containing inflation” and in June it spoke about mitigating “the risk to growth from potentially averse global developments”. A lot will depend on what it says in July. One thing is for sure: it will have to raise its inflation projection.
In my last column, I did write that transmission of the monetary policy has become relatively faster. To illustrate this, I wrote that banks have been raising their loan as well as deposit rates in sync with RBI’s policy rate hikes. This has happened because of two reasons—by making the repo rate, or the rate at which RBI lends to banks, its policy rate; and keeping the financial system continuously in a cash-deficit position to make the repo rate effective.
A banker has pointed out that it’s too early to say monetary policy transmission has become faster as traditionally banks are fast in passing on the higher cost of money to borrowers, but slow in transferring the benefit of rate cuts. The real test of policy transmission will be known only after RBI reverses its policy stance and starts cutting rates. If indeed the banks start paring their loan rates in response to policy rate cuts and the borrowers get the benefit, then one can say transmission of the monetary policy has become smooth. A valid observation.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at firstname.lastname@example.org