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Photo: Reuters
Photo: Reuters

RBI likely to hit the pause button

The central bank will likely reiterate its April view to watch macroeconomic and financial developments in the months ahead

We expect Reserve Bank of India governor Raghuram Rajan to pause on Tuesday and cut a final 25 basis points on 9 August after clarity on a normal monsoon. In our view, the bigger challenge for the RBI is to ensure sufficient liquidity so that banks can pass on the RBI rate cuts to the borrowers to support a recovery.

We have been calling for a step up in permanent/durable liquidity to transmit the RBI rate cuts to bank lending rate cuts for a long time. Needless to say, we welcome the RBI’s decision to inject 70,000 crore in April-May by buying G-secs in open market operations (OMO).

When the economic history of our time is written, this will be seen as an inflection point that set the Indian economy on the path to recovery. We also expect the RBI to roll over FCNR deposits that mature in September if Fed uncertainty stalls portfolio flows.

We expect the RBI to pause on Tuesday. The central bank will likely reiterate its April view to watch macroeconomic and financial developments in the months ahead with a view to responding with monetary action as space opens up.

While we expect the RBI to cut 25 basis points on 9 August, we see little headroom for further easing. After all, the RBI repo rate, at 6.5%, is already running below the medium-term consumer price inflation, at 6.9%, pushing real policy rates into negative territory.

A very shallow recovery cries out for lower lending rates. We estimate growth at a paltry 4.8% (7.6% in the new GDP series) in FY16 in the old GDP series. We forecast old GDP growth at 5.8% in FY17 (7.7% in the new GDP series). This is still well below our estimate of 7-7.5% potential in the old GDP series. In view of this excess capacity, it is no surprise that investment continues to slip to 28.4% in the March quarter.

The good news is that we expect banks to cut lending rates by 50 basis points (bps) by September with the RBI pumping in 3-3.6 trillion in FY17. We calculate that the primary liquidity injection of 3.3 trillion will generate a potential loan supply of 17.1%, up from 10.6% in FY16. With loan demand likely to be lower, the credit market will see excess supply after many years.

The resultant drop in lending rates should boost demand alongside the stimulus of 0.7% of GDP from the Seventh Pay Commission payout. We expect the N.K. Singh committee to raise the centre’s fiscal deficit target to 3-3.5% of GDP for FY18 from 3% to counter-cyclically support growth. This, in turn, will raise capacity and spur investment in 2017-18.

A lower risk-free rate will also enable banks to cut lending rates as it is difficult to reduce risk premium when there is a question mark on recovery. We expect the RBI to step up OMO to 2 trillion to keep its liquidity commitment. This assumes that outflow of $15 billion on maturity of FCNR deposits is counter-balanced by portfolio equity flows of $15 billion. This should lead to excess demand of more than 50,000 crore in the G-sec market, leading to softening of yields.

Will higher liquidity not lead to inflation, one is sometimes asked. How can it when growth is running 200 bps below potential? Inflation will likely rule at a benign 5-6% this year, which is well below the 6.2-6.7% growth-maximizing threshold inflation estimated by the RBI’s Patel committee. At the same time, there are two “extra ordinaries" which will impact headline inflation and need to be adjusted.

The RBI has already said that it will look through the notional 150 bps inflation impact of the 137% hike in housing rent allowance of government employees by the Seventh Pay Commission. We also expect it to ignore the inflation from a jump in oil price from a low base. Although the inflation impact of a jump in oil prices to $50 per barrel from $35 is mathematically higher to say a move to $115 per barrel from $110, the latter situation is surely more “inflationary" than the former.

Finally, we think the RBI will have to keep the door open for rolling over 2013’s FCNR deposits if foreign exchange flows dry up again. After all, former governor Bimal Jalan’s decision to mobilize the India Millennium Deposits in 2001 after raising the Resurgent India Bonds in 1998 laid the foundations of India’s balance of payments security.

After all, the second half of 2016 will likely see forex flows stalling due to four factors: 1. Policy uncertainty surrounding Rajan’s reappointment; 2. FCNR bond outflows on maturity; 3. Bunching up of forex repayments by banks and corporates; and 4. Political uncertainty due to the Uttar Pradesh polls in 2017.

It is true that the RBI has contracted $25 billion of forwards with banks. At the same time, banks’ nostro forex balances work out to $22 billion (after adjusting for $6.5 billion of Iran oil payments). They traditionally maintain $10-15 billion of nostro forex balances for day-to-day transactions. Banks, therefore, may not be able to meet their forwards obligations fully with the RBI.

The central bank will then have to draw down its forex reserves to fund any outflow of FCNR deposits on maturity of say, more than $10 billion.

Indranil Sen Gupta is co-head and economist, India Research, Bank of America Merrill Lynch.

The views expressed here are personal.

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