The fifth review of monetary policy by the Reserve Bank of India in early December will be made in a “once in a lifetime” macroeconomic environment. Banks are flooded with liquidity, there is uncertainty about near-term growth in India, the global system seems on the cusp of a change in the nature of monetary and fiscal policies, capital flows have become volatile and emerging market currencies have begun to wobble.
Analysts have already factored in a repo rate cut, some as much as 0.5%, and it is likely that a cut will indeed happen, given the expected impact on the breadth, depth and duration of an economic slowdown in India, and a drop in inflation, however transient. We at Axis Bank think that the impact of the slowdown in Q3 and Q4 is likely to bring FY2017 growth down from the earlier expected 7.5% to a range of 6% to 6.5%.
However, in the process of decisioning on the drivers of the monetary policy stance, there are many reasons for caution. Start with global uncertainty, the foremost of this being the impending rate hike by the US Federal Reserve. Although markets have priced in a 100% probability, thereby limiting the extent of market volatility, the tenor of the Fed statement might result in a fresh round of speculation on the extent of rate hikes in 2017. The Fed might have to hike more to counter an expansionary fiscal policy. The resulting rebalancing of global portfolios among the developed countries—based on prospective tapering of quantitative easing in Europe and Japan—and to emerging markets might result in further moves in exchange rates.
Commodities prices—particularly metals—have moved up in the past six months, and are expected to rise further in the wake of expected increases in fiscal stimuli in the US, and to a lesser extent in other countries, and with excess capacities in various sectors now coming down, and inventories progressively depleted. How this will impact India remains unclear, but a further weakening of the rupee might amplify the transmission into Indian costs of imports.
Post the withdrawal of legal tender character of high-value notes in India, wholesale price index (WPI) and consumer price index (CPI) inflation is certainly likely to fall over the next couple of months, but the view thereafter remains fuzzy. A structural reduction in costs and prices with the onset of the goods and services tax (GST) next year will take some time to play out.
A constellation of economic metrics in India, which economists call “financial conditions”, has eased significantly in November. First, despite the extraction of some of the surplus through an incremental cash reserve ratio (CRR) hike, there is still surplus liquidity in the banking system, which has brought interest rates down across the yield curve, for bank term deposits, market rates, T-bills and longer-tenor sovereign and corporate debt. The drops are anywhere between 0.1% and 0.45%. This will inevitably bring down bank lending rates, and the costs of market borrowing have already dropped.
However, the first reading on credit growth post the currency switch shows a drop in credit growth from the earlier 9.2% to 8.3%, with some credit balances being reduced with early partial redemptions. A big lever for boosting credit offtake might be to induce a deeper cut in the lending rate. Over the past couple of months, the rupee has weakened from 66.5 to the dollar to 68.66 at the time of writing. Excess liquidity and a weaker domestic currency is considered de facto expansionary policy.
As is inevitably the case, all policy decisions have to balance various objectives, in this case, the lower costs of borrowing versus the impact of lower rates on savings. Although the impact of lower savings in the near future is likely to be low, given weak credit demand, a behavioural change might constrain robust credit offtake, with recourse to high external debt.
Second is a potential adverse impact on the rupee. Sure, the impact might be transient if portfolio debt stocks are rebalanced out of India, but short-term volatility needs to be managed. The gap between Indian 10-year government securities yields and US Treasuries has shrunk by almost one percentage point in the past month and more over the previous quarter. This gap is likely to further increase over the next few months. Foreign portfolio debt outflows have been more than $2 billion in November alone.
Overall, depending on how domestic conditions play out in the country, the Reserve Bank of India will have room for deeper rate cuts than we had deemed feasible a month ago, but the extent will depend on how the system and policy evolves over the next few quarters.
Saugata Bhattacharya is senior vice-president, business and economic research at Axis Bank. The views expressed here are personal.
This is the first in a series of columns ahead of the Reserve Bank of India’s sixth bimonthly policy review on 7 December.