Photo: Reuters
Photo: Reuters

Time running out for rate cuts

If the RBI waits till December, as some suggest, banks will not pass on the rate cuts to borrowers till the April-September slack industrial season

The Reserve Bank of India (RBI) monetary policy committee, chaired by governor Urjit Patel, is expected to debut with a 25 basis point (bp) rate cut on 4 October (and reduce the policy rate by another 25 bps by March). This will send a signal to banks to cut lending rates before the ‘busy’ October-March industrial season picks up, especially as the RBI’s open market operations have already pulled down the 10-year G-sec yield by around 70 bps since March.

If the RBI waits till December, as some suggest, banks will not pass on the rate cuts to borrowers till the April-September slack industrial season. An October cut could, therefore, avoid a replay of 2015 when banks transmitted the January and March 2015 rate cuts only in April. It was governor Jalan’s far-sighted RBI easing through the 2002 drought that propelled the India growth story when the global cycle turned a year later.

The case for lower rates is surely compelling. Growth remains weak at about 4.5% in the June quarter as per the old gross domestic product (GDP) series (and 7.1% in the new series). Industrial production actually contracted by 0.2% in April-July in contrast to 3.5% growth last year.

While consumption should pick up on the 7th Pay Commission payout and a turn-up in rural demand on better rains, there could be some postponement due to expectations of lower prices after the goods and services tax (GST) is implemented in April. Investment is unfortunately unlikely to turn around for at least a year, even if the N.K. Singh committee expands the FY18 fiscal deficit target to 3-3.5% of GDP from 3% in October to support recovery. It is only after lending rate cuts revive demand that capacity will get exhausted to spur capex.

Second, consumer price index (CPI) inflation remains well on track to meeting the RBI’s 5% March 2017 target. With good rains, it will slip below 4.5% in September from 5% in August and 6.1% in July. While oil could heat up beyond $50 per barrel in the winter, it is bouncing from low levels. Although a jump to $50 from $35 per barrel has greater inflationary impact, statistically, that is surely better than $100 going to $105 per barrel. Core CPI inflation is already running at 5%. While we fancy ourselves hawks, it is admittedly hard to espy inflation risks when growth is running far below our estimated potential of 7% in the old GDP series.

We continue to expect the RBI to buy bonds worth Rs90,000 crore in the open market by March. This will be in addition to the Rs1.1 trillion it has bought since April and provide sufficient liquidity to translate policy rate cuts into bank lending rate cuts. Let’s put in context what governor Patel has assured: “... (the) path is well set that we want to eliminate that (structural money market) deficit… calibrate(ing) it in the least disruptive and most beneficial manner."

After all, the RBI’s tight liquidity policy had constrained loan supply below the loan demand (Re1 of RBI liquidity translates into Rs4 of credit). Not surprisingly, real lending rates are stuck at a 20-year high when the world is caught in a recession that threatens to be longer than the Great Depression. In our view, lower lending rates are sine qua non to bring down bank’s non-performing assets (NPAs). Finally, an RBI rate cut will support the rupee in case of a global risk-off.

As it is, the BSE Sensex 1-year forward price to earnings ratio, at 17x, has climbed above the 14.5 average, although Sensex net profit growth saw no growth in the June quarter, down from 4% last time. Lower rates will attract foreign portfolio investor (FPI) equity inflows to rate-sensitive stocks, such as autos and banks. It will also sustain FPI debt flows that are searching for capital gains in falling yields.

We expect the RBI to sell from foreign exchange reserves in November if foreign currency non-resident (FCNR) outflows cross $15 billion. Given that $10-15 billion of banks’ nostro foreign exchange balances of about $30 billion are typically needed for day-to-day transactions, they will be hard pressed to deliver beyond $15 billion to the RBI, without calling back foreign exchange loans and shrinking credit even further. That said, we continue to expect governor Patel to add to foreign exchange reserves at every opportunity to guard against contagion in our uncertain world.

True, import cover, at 9.4 months on 1-year forward basis, is running above the 8 months usually needed for INR stability. Still, the FPI debt and equity portfolio has climbed to 120% of foreign exchange reserves from 70% in pre-crisis years.

A monetary policy that is supportive of recovery will equip the economy to cope with three event risks ahead. First, money market liquidity as well as public investment will surely swing on the mobilization under the Voluntary Disclosure of Income Scheme. Second, how much of the 2013’s FCNR deposits of $23.8 billion in the 3-year window are retained is another open question till November. Finally, it remains to be seen how the global markets react to the US presidential elections and if the Fed finally hikes rates on 16 December.

Indranil Sen Gupta is co-head & economist, India Research, at Bank of America Merrill Lynch. Views are personal.

This is the third in a series of expert columns in the run-up to RBI’s bi-monthly policy meeting on 4 October.

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