Governor Y.V. Reddy again surprised the market. But this time the surprise was one of inaction, contrary to increased expectations of a cut in policy rates. I’m sure the business press will be full of splenetic outbursts against the governor. After all, it is always easy to fault the central bank for miscommunication and question its guidance, but investors should do some introspection to understand why they misread RBI (Reserve Bank of India).
Rajeev Malik, executive director, JPMorgan Chase Bank, Singapore
There were two main reasons offered by those betting on a policy rate cut by RBI: (1) moderation in growth; and (2) wider interest rate differentials. Both are relevant, but the importance of both factors has been overplayed. Indeed, suggestions by some for cutting the cash reserve ratio and policy rates in one go perhaps only shows a near complete lack of understanding of the current economic dynamics, and of the art of, and the signalling in, monetary policymaking.
India’s economic growth is likely to moderate, but the magnitude and breadth of the slowdown should not be an elevated concern at this juncture so as to warrant immediate cut in policy rates. The moderation so far is not unexpected, and, more importantly, is what the tighter monetary policy was designed to achieve. Admittedly, a scenario of additional softening in external demand owing to a US recession could trim around 0.5 percentage point from the full-year GDP (gross domestic product) growth.
Higher trend growth for India is desirable, but I just don’t think the government can afford to take a chance with the emergence of inflation problem in the run-up to the next general election. Inflation expectations have declined meaningfully in recent years, and the government should be well aware that voters do not favour record high growth that comes with the price tag of higher inflation.
A rate differential is an important factor in attracting capital inflows, but that argument for cutting policy rates only shows that few analysts are thinking deeply or comprehensively about the issue. The differential is already so wide—and likely to widen further as the US Federal Reserve announces more rate cuts—that small cuts by RBI will have little effect on capital inflows, but could risk boosting domestic demand and asset prices which, in turn, could increase concerns over inflation that is partly suppressed owing to the paralysis in the government over the impending hike in fuel prices. However, large cuts, which might have a meaningful impact on rate differential-driven capital inflows, are not needed, given the still strong growth momentum.
Further, the wide rate differential is not the main reason for the appreciation pressure on the rupee, though it does add to that pressure. Thus, there was little reason for RBI to risk the domestic agenda by cutting rates now when the pace of monetary expansion is already running ahead of its indications, despite a welcome moderation in loan growth.
RBI will likely ensure relatively comfortable liquidity in money markets. Lower volatility in overnight rates will also lower the uncertainty premium and prompt banks, hammered by the excessive uncertainty over the outlook for overnight rates last year, to ease their rates. Indeed, banks have scope to ease deposit and lending rates without RBI cutting policy rates.
Governor Reddy indicated that liquidity management will continue to assume priority in the conduct of monetary policy, and reiterated the need for a more active management of the capital account of the balance of payments.
But the policy statement and Reddy’s post-policy comments appeared to be more hawkish than I expected. India’s rate cycle will turn around this year, but beginning that journey on Tuesday was premature, despite what some spin doctors had to say.
Rajeev Malik is executive director, JPMorgan Chase Bank, Singapore.