BackRBI may combine repo rate hike with MSF rate cut
RBI will complete the unwinding process once it is convinced that the currency market is stable and inflation under control
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Nobody will be surprised if the Reserve Bank of India (RBI) raises the repo or repurchase rate by 25 basis points (bps) to 7.75% on 29 October when it announces its second quarter monetary policy. It may do so to fight rising inflation and, more importantly, rising inflation expectations. One bps is a hundredth of a percentage point.
The wholesale price inflation in September rose to 6.46% from 6.1% in August and a recent low of 4.58% in May. Besides, the July inflation data was revised upwards to 5.85% from the original estimate of 5.79%. On a seasonally adjusted basis, wholesale inflation rose 1.2% in September, its fourth successive rise in excess of 1%. The driving factor for inflation in September was primary goods inflation with food inflation rising 18.4%.
For the record, the average rise in food inflation in the eight years since 2005 has been 10% and during this period only in eight months food inflation had been higher than the current level with the highest being 22% in February 2010, according to a Credit Suisse analysis.
The so-called core inflation, or the non-food, non-oil manufacturing inflation, rose marginally in September to 2.10% year-on-year against 1.97% in August.
Consumer price inflation too rose to 9.84% in September, sharply higher than 9.52% in August. What is more critical is that the core consumer price inflation rose 8.4% after dropping to 7.7% in June. This makes it pretty evident that a slowing economy has not impacted the inflation level in the services sector.
Indeed, when food inflation lowers, it will have a positive impact on both wholesale and retail inflation, as food and beverages have close to 50% weight in retail inflation, more than double what it has in wholesale inflation. But this does not necessarily mean that RBI will leave its policy rate unchanged hoping that a good monsoon will change the trajectory of food inflation. This is because adjustment in administered prices and the rise in imported inflation on account of the depreciation in local currency will continue to add to inflationary pressures.
Meanwhile, most activity indicators including factory output data, HSBC purchasing managers’ index (both for manufacturing and services) and auto sales have remained subdued even as exports growth has been positive for the past three months and the banking sector’s credit growth has been 17.7% in the first half of the fiscal year.
Another source of relief for the regulator could be the external sector data. The trade deficit for September was $6.7 billion, much lower than what most analysts had expected, and the best monthly data in the past two-and-a-half years.
This, along with stability of the local currency, may encourage RBI to continue unwinding the liquidity tightening measures. So, a 25 bps hike in the repo rate could be accompanied by an identical cut in the marginal standing facility (MSF) rate to 8.75%. After hiking the MSF rate in mid-July by 200 bps to 10.25% to make short-time money expensive and stamp out currency speculators from the market, RBI has reduced it by 125 bps in two stages to 9%. It has also raised the repo rate once by 25 bps to 7.50%. A combination of repo rate hike and MSF cut will restore the original gap between the two to 1%, the so-called liquidity adjustment facility corridor (LAF). Restoration of the LAF corridor is only one part of the unwinding process. Will RBI also lift the cap on the liquidity infusion into the system through its repo window? Originally, it was capped at 1% of the banking system’s deposit liabilities and later the borrowing limit was reduced to 25 bps of an individual banks’ deposit base. By doing so, RBI forced banks to pay more for borrowing money as MSF was made the anchor rate instead of the repo rate. Currently, banks can borrow up to 0.5% of their deposits from the repo window and another 0.5% through the refinance window at the same rate. But about 20% of their liabilities is linked to the higher MSF rate as all short-term rates such as overnight call money, commercial papers and certificate of deposits are linked to MSF.
RBI has also recently opened a term repo window where banks can borrow up to 14-day money at a rate which is higher than the repo rate but lower than the MSF rate. They can borrow only 0.25% of their deposits through this route. If indeed RBI lifts the cap and allows banks to borrow as much as they want from the repo window, then the repo rate will become the anchor rate and banks’ borrowing cost will come down. But with retail inflation at 9.84%, will RBI run the risk of making repo at 7.75% the anchor rate and following an accommodative monetary policy? My guess is the central bank may, at best, lift the cap partially and allow banks to borrow, say, up to 0.75% or even 1% of their deposits from the repo window. It will lift the cap entirely and complete the unwinding process once it is absolutely convinced that the currency market is stable and inflation under control. Indeed, the rupee has gained around 10.5% since it hit its lifetime low in August but the currency market is still truncated with RBI meeting the demand of oil marketing companies (OMCs) outside the market. So far, it has spent at least $8 billion to meet the demand of OMCs but, at the same time, there has been an inflow of at least $10 billion through fresh NRI deposits. RBI may complete the unwinding process by November-end when it plans to close the concessional swap window for banks gathering NRI deposits.
Tamal Bandyopadhyay keeps a close eye on everything banking from his perch as Mint’s deputy managing editor in Mumbai. He is also the author of A Bank for the Buck, a book on HDFC Bank. Email your comments to bankerstrust@livemint.com
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