Time running out for RBI rate cuts
We expect the Reserve Bank of India (RBI) monetary policy committee (MPC) to cut policy rates by a quarter of a percentage point on 2 August. In our view, time is running out. An RBI rate cut now would signal a lending rate cut to banks before the start of the “busy” industrial season in October. As 2015 showed, “busy” season RBI rate cuts do not transmit to lending rate cuts.
Delays would push the next lending rate cut to the “slack” season beginning April. We reiterate that lending rate cuts hold the key to recovery. It is only when the cost of credit comes off that demand revives to exhaust capacity and spark investment. This would also buttress RBI’s efforts to improve banks’ asset quality as the bulk of non-performing assets are cyclical, fuelled by high rates in a long global recession.
We flag six reasons why the RBI Monetary Policy Committee’s (MPC) inflation concerns are likely to continue to dissolve:
First, inflation risks are muted. Despite a tomato price spike, food inflation is falling on a good summer rabi harvest. We track July inflation at about 2% atop June’s 1.5%. We expect consumer price index (CPI) inflation to average a weak 3% in 1HFY18 and 3.7% in FY18, well within RBI’s 2-6% inflation target. RBI has itself cut its inflation forecast to 2.5-3.5% from 4.5% in 1HFY18 in the last policy meeting. Core CPI inflation (when adjusting petrol and diesel prices) has slipped to 3.7% from 4.8% in October rather than being sticky. RBI now finds that “the industrial outlook… indicates that pricing power remains weak”.
Secondly, we do not expect the output gap to close anytime soon, with high lending rates delaying recovery. This obviously curbs pricing power. Old series GDP growth, at about 5.5%, remains well within our estimated 7% potential. RBI also acknowledges “…deceleration of activity… since Q2…”
Third, rising hopes of a normal monsoon should dampen agflation. Autumn kharif sowing is also higher than last year, although the drop in oilseed cropping is a concern.
Fourth, GST rates are neutral to the inflation outcome.
Fifth, the second round effects of the hike in housing rent allowance (HRA) by the 7th Pay Commission can hardly be considered material as the first round is largely statistical. As a large number of government employees reside in government quarters, they would not be financial beneficiaries.
Sixth, “imported” oil inflation risks are coming off on lower oil prices and a softer US dollar.
This naturally begs the question, can RBI really cut 50 basis points as Ravindra Dholakia, an MPC member, has called for? We see a second cut only if good monsoons water a sufficiently bumper crop to sustain low agflation. We believe the long global recession justifies one 25 basis points (bps) cut that takes the negative real repo rate to 50 bps, assuming 6.5% long-term CPI inflation as a proxy for inflation expectations. One basis point is one-hundredth of a percentage point. Then RBI governor Bimal Jalan had similarly cut the policy rate to 4.5% in August 2003, below the then 5% wholesale price index (WPI) inflation target. This scripted the India growth story without fanning inflation. Second, RBI’s 50 bps cut in early 2015 went for nought as tight liquidity impeded transmission to bank lending rate cuts. Finally, the rate differential with the US Fed remains a comfortable 500bps even after a December Fed hike.
We continue to expect RBI to recoup foreign exchange reserves as governor Urjit Patel is already doing. Foreign portfolio investments jumped to 120% of FX reserves from 80% in 2007-08. Just as importantly, the FPI debt portfolio has risen to about 20% of FX reserves after the hike in investment limits. Second, it is true that the import cover looks comfortable at 11 months on a 1-year forward basis, above the eight months we deem needed for rupee stability. We are still concerned that this remains well below the import cover of 14+ months during the previous upcycle.
In our view, the improvement in import cover largely reflects lower oil prices and weak import demand rather than any fundamental accretion to FX reserves. Import demand can turn up very quickly with recovery: imports doubled to $111bn in FY05 from $50.5bn in FY02. Finally, Bharatiya Janata Party (BJP) governments typically conservatively build up FX reserves. Governor Jalan (and governor Y.V. Reddy) laid the foundations of our balance of payments security by amassing FX reserves in the Vajpayee regime, and similarly governor Raghuram Rajan after the BJP’s 2014 victory.
Finally, we also continue to expect RBI to switch to open market operation purchases from the current sales auctions. We estimate that it would need to inject $35 billion of reserve money in FY18, double the current year-on-year $15 billion (adjusted for demonetization). Although demonetization has shifted money to bank accounts from the public’s pocket, M3 growth, the measure for overall liquidity, is running at 7.4%, below half its 15.5% average. Not surprisingly, this has constricted loan growth to 6.1%, again well below its 18% average.
Indranil Sen Gupta is economist and co-head, India research, Bank of America Merrill Lynch. The views are personal.