Photo: Bloomberg
Photo: Bloomberg

Central bank’s hands are tied

With inflation expected to settle within 5.5-6% next year, the room to lower benchmark rates is limited

Weak price pressures and a delay in the US rate normalization plans prompted the Reserve Bank of India (RBI) to ease monetary policy by 125 bps to 6.75% earlier this year. One basis point is one hundredth of a percentage point. The window for further easing is closing fast. Notwithstanding low inflation, real interest rates should be kept above zero. We expect RBI to sit pat in December and also expect the policy stance to remain in neutral into the next fiscal.

With the bulk of disinflation already past, consumer price index (CPI) inflation rose to 5% year-on-year on higher food prices, primarily pulses and vegetables. Urban consumption appears to be rising, which will also get a hand from the Pay Commission’s proposals due to take effect next year. But a pickup in rural consumption will be delayed by depressed wage growth on the back of a weak monsoon. Also, one of the key assumptions for pursuing an easy monetary policy was that the fiscal deficit targets would be met. Next year’s deficit target of 3.5% of gross domestic product (GDP) appears difficult. Spending is set to rise following the Pay Commission’s proposals and additional capital infusion into banks.

The Pay Commission estimated that the add-on expenditure will be to the tune of 0.65%-0.7% of GDP, of which about 0.5% is likely to impact the central government’s finances. Meanwhile, weak divestment proceeds will crimp revenue. Oil prices remain low but have not fallen beyond earlier lows.

On revenue, the nationwide tax bill still faces legislative hurdles, while corporate tax rates will be lowered over the next few years. Combining these headwinds, the likely options for next year’s fiscal math point to restrained capital spending, the need to source additional tax revenues or renege on deficit targets. These dynamics raise the risk of a slippage in next year’s fiscal target, limiting the room for additional monetary stimulus.

With supply-side fixes yet to be addressed and low commodity prices largely factored in, a tighter policy is necessary to rein in inflation when growth makes a comeback. This is even more relevant as RBI shifts its attention beyond January 2016 to a medium-term inflation target of 4% (target range 2-6%).

Apart from inflation, policymakers face another concern: the need to preserve positive real interest rates. This assumes importance as since the global financial crisis, savers have faced persistently negative real returns (based on one-year deposit rates adjusted for inflation). This has seen the gross savings rate fall from above 36% of GDP in 2007-08 to below 30% last year. Deposit growth is at multi-year lows.

Households account for two-thirds of national savings, of which bank deposits make up more than half of the financial savings. In the face of negative returns, there has been a shift away from financial savings to physical assets. This hurts growth and aggravates external imbalances at the same time. Policymakers will have to reverse the trend in savings and weak deposit growth. The need to preserve positive real interest rates leaves little room for nominal rate cuts.

Since H1 20114 (first half), the RBI has cut the policy rate by 125 bps, prompting banks to cut deposit rates as well. The pending adjustment in small saving schemes will lead to further softening in deposit rates. Inflation, meanwhile, is beginning to perk up and will likely prove sticky for reasons noted above. Real rates seem likely to soften rather than rise going forward.

While low inflation implies a broadly low-rate environment, the central bank will be wary of the implications on savings. The RBI has signalled that real rates will be maintained between 1.5% and 2%. With inflation expected to settle within 5.5-6% next year, the room to lower benchmark rates is limited.

Radhika Rao is vice-president, DBS Group research.