Home >opinion >online-views >Monetary policy: RBI may hold rates

In cricketing parlance, this is a reasonably good pitch to bat on. India’s consumer price inflation rose 7.31% in June, a 43-month low, and much lower than consensus market expectations. Wholesale price-based inflation (WPI), too, slowed to a four-month low of 5.43% in June. Factory output gained 4.7% in May, the fastest pace in 19 months, and the HSBC manufacturing Purchasing Managers’ Index (PMI), a survey-based measure of manufacturing activity, rose to 53 in July, a 17-month high, in response to a surge in production backed by new orders.

Macroeconomic data are certainly looking better as a backdrop for Reserve Bank of India (RBI) governor Raghuram Rajan’s first monetary policy review after the National Democratic Alliance government presented its maiden budget. The rapid pace of improvement in the monsoon over the past few weeks, which narrowed the rainfall deficiency, is another piece of good news.

Most analysts had expected retail inflation at around 7.95% and WPI at 5.8%. Although food prices remain high—rising 8.1% from a year earlier and 1.2% in June over May—a decline in fuel inflation, to 9% in June from 10.5% in May, led to the easing of WPI inflation. In May, WPI inflation had quickened to 6.01%, the fastest pace since January. While the drop in WPI in June is, indeed, good news, the upward revision of April inflation data, from 5.2% to 5.55%, is a matter of concern.

The stubborn manufacturing inflation is also something RBI is certainly not feeling comfortable about. The so-called core inflation, or the non-food, non-oil inflation, in June rose to 3.9%, against 3.8% in May. Read in conjunction with the factory output data of May and PMI data of July, it seems that demand pressure is slowly coming back to Asia’s third largest economy.

The growth in May industrial output is supported by a cyclical recovery in both basic goods and capital goods as well as an improvement in consumer goods, driven by higher sales of automobiles, among other things, while a flood of new orders from both domestic and external sources led to a surge in the HSBC manufacturing PMI in July, its highest since February 2013.

Indeed, Rajan should feel happy with the latest consumer inflation figures, as in the Indian central bank’s scheme of things, consumer inflation is the all-important data to watch out for and WPI inflation doesn’t matter much. An RBI panel, headed by deputy governor Urjit Patel, has recommended an inflation-targeting monetary policy. It has also charted out a glide path for retail inflation—8% by January 2015 and 6% by January 2016.

RBI has not formally adopted the inflation-targeting mandate as yet (as the government does not seem to be excited about the idea), but informally, containing inflation is the monetary policy’s main objective.

Most analysts are optimistic about retail inflation being contained within 8% by January 2015, but they feel it will not be easy to bring it down to 6% in the next one year. That can happen only if the government supplements RBI’s monetary stance with an aggressive approach. It has already given an inkling of what can it do by marginally revising procurement prices offered to farmers, talking tough against hoarders and releasing foodgrain stocks in the open market.

Rajan is unlikely to be in a hurry to ease monetary policy soon and go for a rate cut even as RBI will keep a close tab on the progress of the monsoon. Geopolitical risks are also rising and this can have an impact on commodity prices.

Since he took over as RBI governor in September, Rajan has raised the central bank’s key policy rate thrice before leaving it unchanged at 8% in the 3 June policy meeting. On 5 August, too, he is unlikely to touch the policy rate even as the analysts will closely watch his stance.

The guidance of the June policy read: “If the economy stays on this course, further policy tightening will not be warranted. On the other hand, if disinflation, adjusting for base effect, is faster than currently anticipated, it will provide headroom for an easing of the policy stance." I guess Rajan will stick to this commitment on Tuesday but there is a very slim chance of a rate cut in 2014.

Interest rates falling?

Meanwhile, with the new benchmark 10-year government paper trading at 8.4%, much lower than the existing 10-year bond, fund managers and bond dealers have started expecting that the rate of interest will come down soon. The logic is simple—many loans are typically benchmarked to the 10-year gilt yield and, hence, lower yield paves the way for lowering loan rates. The fall in inflation is also encouraging this line of thinking.

However, at this point, their optimism seems to be misplaced. A new benchmark paper always gets traded at a lower yield compared with an existing benchmark paper, which often is not very liquid. The supply of the new paper is always much less compared with the existing paper, and as dealers rush to buy the new paper, high demand pushes bond prices up and yields down.

What we are seeing today is an exaggerated movement, and more supply will narrow the gap between the yields of the two benchmark papers. At this point, there is no reason to get excited about falling interest rates.

Another round of SLR cut?

So, will the August policy be a non-event? It could be, but I will not be surprised if Rajan cuts banks’ compulsory bond holding requirement, or the so-called statutory liquidity ratio (SLR), once again. In the June policy, he brought it down to 22.5% of deposits.

The actual level of bond holding by the banking sector is, however, at least 28%. With credit offtake being very low, banks are busy buying gilts and the government is not complaining as the total borrowing requirement in 2014-15 is 6 trillion to bridge an estimated 4.1% fiscal deficit.

In accordance with the Basel III framework on liquidity standards, Indian banks will be required to maintain the minimum liquidity coverage ratio, or LCR, in a phased manner, starting at 60% from January 2015. By January 2019, the banking sector will be required to keep 100%. LCR refers to highly liquid assets held by banks to meet short-term obligations. It is designed to ensure that banks have necessary assets on hand to ride out short-term liquidity disruptions.

They need to hold an amount of highly liquid assets, such as cash or treasury bonds, equal to or greater than their net cash over a 30-day period. Since bonds held to meet LCR will be outside the SLR obligation, RBI needs to bring down the floor for government bond-holding gradually as otherwise after LCR and SLR, the banks will be left with very little money to meet the loan demand of the private sector. The June SLR cut could be the beginning of a phased paring of government bond-holding of the Indian banking system.

Tamal Bandyopadhyay, consulting editor of Mint, is adviser to Bandhan Financial Services Pvt. Ltd, India’s newest bank in the making. He is also the author of Sahara: The Untold Story and A Bank for the Buck. Email your comments to bankerstrust@livemint.com

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