The focus is back on interest rate setting in India with the Reserve Bank of India’s (RBI’s) monetary policy decision due on 2 February. Segments of the market expect RBI to bring interest rates down, probably as the RBI governor indicated in December that the stance of monetary policy remains accommodative and he would cut rates when opportunity makes itself available, without compromising on the next target for Consumer Price Index (CPI)-based inflation at 5% by March 2017.
It is never easy to predict the exact course of monetary policy with the recent heightened global risks, including the uncertainty regarding China. But what appears to be changing and could support a repo rate cut is the sharp fall in the commodity prices from the last time that RBI reduced the repo rate by 50 basis points in end-September 2015. From then, Brent oil has fallen off by another 38%, CRB index is down by 22% and the CRB metals index is down by 16%.
These are obvious comforting factors for inflation, despite some likely upsides to the CPI inflation levels with the Pay Commission increasing the house rent allowance and with a probable increase of 2% in the service tax rate in the Union budget. But RBI said it would see through these increases as this inflation as it is not directly based on increases in aggregate demand.
The other comforting factor is that the onset of the rate hiking cycle of the US Fed has now passed off without creating much disturbance for the financial markets. Further, with global growth falling off and with deflationary conditions expected to continue, the chances of US Fed staying on a sure path for interest rate increases appear difficult. This might lead to lower outflows on the capital account for emerging market economies and help them to stay on a path of accommodative monetary policy. And with domestic growth remaining muted, the basis for a rate cut appears to be firming.
Though this might appear to open up room for further accommodation, we think RBI might not be willing immediately to reduce rates at the February meeting. And there could be reasons domestic and external. On the external front, the recent volatility of the global currency markets and the slide in the Indian rupee could lead RBI to stay on the back-foot for the moment.
Anyway, with the growth in the emerging market space looking weak and no real pull for growth in India yet, the economy had been witnessing capital outflows from both the equity and the debt space. Fiscal year to date, debt flows are marginally positive at $900 milllion while equity flows are negative by $3.8 billion.
On the domestic front, the key would be the fiscal and the ways the government is able to bolster the revenue side in its effort to absorb the huge additional burden of OROP (one rank one pension) and 7th Pay Commission.
One, the government might stagger the pay-outs, but if they decide to put all in the first year, the path of fiscal consolidation is likely to be missed, implying a push to aggregate demand and a resultant inflation pressure. Therefore, in my opinion, RBI might find it prudent to wait for the strategy followed in the budget to decide on the future pace of inflation build-up/crumble to decide on its rate action. And, if it is satisfied, RBI has every scope to move immediately after the Union budget and cut its repo rate by 25 bps. In 2015, RBI had cut by 25 bps on 3 March, just a few days post the budget presentation. A basis point is a hundredth of a percentage point.
Our base case is for RBI to not rock the market with a mid-course adjustment and stay with the scheduled policy date in April. This might also enable them with a better scope for assessing the global risks. Given our expected trajectory on inflation, we think there could be scope for RBI to reduce the repo rate by a further 50 bps.
The key struggle has, however, been the transmission whereby only about 60 bps out of 125 bps reduction in repo rate has been transmitted. Beginning April, with the base rate calculation to be based on Marginal Cost of Funding, another 25-30 bps reduction in the lending rate could be due. However, beyond this, further reductions in the repo rate might not lead to a full transmission as banks continue to face challenges from stressed assets.
Similarly, expectations of a large borrowing programme of the central and state governments in FY17 can lead to the new 10-year yield to remain sticky at around the 7.5-7.65% zone for a long period, despite RBI’s rate cuts.
Indranil Pan, Group chief economist, IDFC Bank
This column reflects the author’s personal views.