A compelling case for easing by RBI
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The Reserve Bank of India (RBI)’s monetary policy committee (MPC) is likely to keep interest rates on hold on 6 April. Still, the case for monetary easing is becoming stronger. In the 8 February MPC meeting minutes, governor Urjit Patel noted that “…by shifting the stance, accommodative to neutral, there will now be sufficient flexibility to move, in either direction, depending on the data.” Since the stance has been hardened, RBI will likely wait for transfer of the “special” dividend to the fisc from demonetized notes and good rains before cutting rates in August.
Why ease? Because higher rates and demonetization would likely push recovery to the second half of the year. Second, inflation should remain well within RBI’s 2-6% target range. Core inflation is coming off due to excess capacity.
Finally, RBI rate cuts should support the rupee by attracting equity inflows from foreign portfolio investors (FPIs) at a time of global uncertainty.
The prevailing higher lending rates and the demonetization shock look set to push recovery to the second half of the year. April-January industrial growth actually slipped to 0.6% from 2.7% last year.
While the gross value added growth, at 6.6% for the December quarter, exceeded expectations, it was well below the 7.5-8% range expected prior to demonetization. Our channel checks support the MPC’s view that the economy is recovering from demonetization.
That said, old series gross domestic product (GDP) growth, at 4.5%, was running well below our estimated potential of 7% even before.
A recent RBI study also points to slack in the economy.
Consumer price index (CPI)-based inflation is expected to remain well within RBI’s 2-6% target range. We expect 1H17 inflation to average 4%. Core CPI inflation, which excludes food and fuel (i.e., petrol, diesel, cooking gas, kerosene and other fuels), has also eased to 4.2% from 4.6% in October, when RBI last cut rates. While wholesale price index-based inflation has jumped to 6.6% on higher oil prices, it will likely soon moderate on base effects, if oil prices stabilize around the current levels. While the chances of an El Nino by July are rising, rain clouds could travel to India by then.
Isn’t core CPI sticky? It’s actually coming off. This begs the question, how should core CPI be calculated?
A complication is that fuel falls under two classifications – 1) Fuel and light, and 2) Transportation – in the CPI basket. We exclude petrol, diesel, liquefied petroleum gas, kerosene and other fuels under both. They are all driven by global oil shocks, outside RBI’s policy control.
The RBI rate cuts should support the rupee by attracting FPI equity flows, although global uncertainty is often cited as a reason for RBI to pause. The FPI equity portfolio, that responds to growth, at $400 billion, is over five times the size of the FPI bond portfolio. As seen in July 2013, hiking rates did not attract FPI debt investors who lost heavily on their existing investments in government securities.
While the rupee has now appreciated to Rs65/dollar levels, we expect it to weaken as trade seasonality turns in favour of imports from exports from mid-April. In any case, RBI has to recoup foreign exchange reserves.
The FPI portfolio has jumped to 120% of foreign exchange reserves from 80% in 2007-08.
Some relief should come given that bank lending rates should ease by 50-75 basis points in the April-September “slack” industrial season, with RBI governor Urjit Patel repeatedly stressing the need for lower borrowing costs.
Banks have already cut Marginal Cost of Funds Based Lending Rate (MCLR) after the prime minister’s 31 December speech. We estimate that RBI needs to buy Rs1.2 trillion through open market operations (of which the budget committed Rs75,000 crore to buybacks) to push liquidity in the money market to neutral by March 2018.
This, in turn, would sustain excess demand in the government securities market, given a lower central fiscal deficit as well as excess supply in the loan market. This assumes that banks will be able to retain about Rs2 trillion of deposits after the dust settles on demonetization.
Lower rates would rejuvenate demand, support recovery and scale down generation of banks’ non-performing assets. Bank asset quality would also benefit from the implementation of deputy governor Viral Acharya’s plan for resolving stressed assets. We believe that market fears of capital inadequacy constricting loan supply from public sector banks and hurting growth are overdone. In our view, both the government and RBI have every incentive to recapitalize banks–either directly or through Acharya’s proposed quasi-government National Asset Management Co. route–to support recovery.
We welcome the introduction of a standing deposit facility, by amending the 1934 RBI Act, to refine the monetary policy framework in line with standard international practices.
Most central banks target a market rate offering standing deposit/lending facilities at, say, 50 basis points lower or higher. We, however, expect the public to withdraw the bulk–Rs12.5 trillion of the Rs17.3 trillion of demonetized Rs500/1000 notes—by September to meet transaction demand. In fact, Rs10.3 trillion has already been drawn down.
Indranil Sen Gupta is economist and co-head of India Research at Bank of America Merrill Lynch, in Mumbai.