BackRBI: Permanent liquidity key
The biggest challenge for RBI is to provide sufficient permanent liquidity, if foreign portfolio investor equity inflows do not revive till the global market prices in the first Fed fund rate hike
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The Reserve Bank of India (RBI) should pause on Tuesday after the 50 basis point (bp) cut last time. It should cut a final 25 bps in February with inflation set to meet its “under" 6% inflation target in January 2016. Although we have led the Street in calling for RBI rate cuts, the scope for further easing is limited, in our view. If one uses medium-term Consumer Price Index (CPI)-based inflation of about 7% as a proxy for inflation expectations, RBI is already beginning to run negative real policy rates. It is true that former governor Bimal Jalan had cut all the way to 4.75% in 2003 to revive growth but RBI was then targeting Wholesale Price Index (WPI)-based inflation that averages about 5%.
That said, I expect CPI inflation to persist in a benign 5-6% range in 2016 with the US Federal Reserve tightening, holding global commodity prices in check. Yet, it will likely rise to 5.5-6% in the March quarter on reversal of base effects. Although I fancy myself a hawk, I am not overly concerned about inflation with growth running at 5-5.5% levels (in the old gross domestic product, or GDP, series), well below our estimated potential growth of 7-7.5%. Needless to say, the progress of the monsoon will determine whether RBI is able to meet its March 2017 target of around 5%.
At the same time, one continues to expect the Narendra Modi government to use supply side measures rather than resort to monetary policy action against a rain shock. Yes, the upward revision in imputed rent of government quarters after the pay hike by the Seventh Pay Commission could put some pressure on CPI inflation. Given this is notional, we expect RBI and the markets to look through it.
The biggest challenge for RBI, in our view, is to provide sufficient permanent liquidity, if foreign portfolio investor equity inflows do not revive till the global market prices in the first Fed fund rate hike, which one expects on 16 December. Markets will also likely look for a turnaround in December corporate earnings as the S&P BSE Sensex is trading at around 17x one-year forward price-to-earnings ratio which is somewhat higher than the 14.5x average.
Against this backdrop, the market will look to RBI for a signal that it will conduct open market operations (OMO) to buy government securities (G-secs) to supply “permanent" liquidity in case capital inflows continue to stall. We estimate that it needs to inject about $30 billion this year. RBI has so far supplied about $2 billion as it has sterilized the liquidity from maturity of forex forwards with banks by selling G-secs through the OMO window.
We would not be unduly worried if finance minister Arun Jaitley raises the FY17 fiscal deficit target to a still-very-conservative 3.9% of GDP from 3.5% to accommodate the 0.7% of GDP outgo due to the Seventh Pay Commission award. In our view, the only trigger left is a consumption recovery of 1% of GDP driven by (1) lending rate cuts; (2) the 7th Pay Commission award; (3) household savings due to lower oil prices and (4) a hike in wheat prices to implement the Swaminathan formula before the early 2017 Uttar Pradesh polls. We do not expect the capex cycle to turn before 2017 in view of high real rates and surplus capacity.
We continue to expect RBI to hold ₹ 65/dollar as governor Raghuram Rajan has indicated the rupee’s fair value at ₹ 62-64/dollar. At the same time, RBI will not want to waste precious foreign exchange reserves on cross-currency pressures from a stronger US dollar. Still, seasonal support should prevent any significant depreciation in the rupee in the March quarter.
Indranil Sen Gupta is India economist at Bank of America Merrill Lynch. Views are personal.
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