RBI’s premature change in stance

The 25 basis point reduction in repo rate by the Reserve Bank of India (RBI), in my view, was broadly to accommodate market expectations and is probably indicative of the choice RBI has made to remain accommodative, notwithstanding the fact that core consumer price index inflation has been rising recently.

One basis point is one-hundredth of a percentage point.

Importantly, RBI has adopted an aggressive approach to address the enduring liquidity shortfall. With the articulation of an accommodative stance, RBI seems to have aligned itself with the government’s fiscal stance (revenue expenditure growth of 12%), which attempts to boost consumption.

Adoption of aggressive stimulus ahead of sufficient structural adjustments, however, could shorten the longevity of demand recovery as repercussions of higher inflation and widening external deficit re-emerge.

RBI plans extensive purchase of government securities to take the average liquidity deficit of ₹ 1.6 trillion (Q4 FY16 average) to a neutral level over a period of 12-24 months. Hence, in absence of adequate external flows, RBI intends to aid transmission of lower policy rates through its interventions in the government securities or G-secs (through open market operations or OMOs) and money market.

As per the change in the framework, there will be a normal incremental reserve money requirement of ₹ 20,000 crore a month in financial year 2016-17 (FY17), implying a growth of 12%. In addition, with the current liquidity adjustment facility (LAF) balance of ₹ 1.3 trillion and with RBI moving towards OMO purchase of ₹ 10,000 crore per month, neutrality will be achieved in 13 months. Overall, there is a likelihood of OMO purchase of ₹ 3.6 trillion at the outer limit, assuming no increment in foreign exchange (FX) reserves of RBI. The risk to these assumptions are FX outflows from upcoming foreign currency non-resident deposit redemption, continued rise in currency with the public, stronger credit growth and sustenance of credit-deposit wedge.

RBI maintains that the consumer price index (CPI) will slow to 5% from the current 5.2% as it has not considered the impact of 7th Pay Commission, which has partly been adopted by the Union budget and subsequently will be adopted by state governments and public sector companies.

According to RBI, full implementation of the pay commission and one-rank one-pension (OROP) will have an impact of 100-150 basis points on CPI inflation. Also, the list of upside risk to inflation highlighted by RBI, such as the recent rise in commodity prices, higher government revenue spending, persistence of inflation in services sector, is much more realistic and dominating than the downside risks.

Clearly, RBI has taken a benign view on inflation than what might be realistic. In my opinion, there is indeed a case for retail inflation rate to move up by 100-150 basis points from the current 5-5.5%; the conviction has been reinforced by the collected countercyclical stance adopted by government fiscal and RBI’s monetary policy stance.

With nominal gross domestic product (GDP) growth assumed at 11% in the Union budget for FY17, implied GDP deflator-based inflation is projected at 3.4%, higher than 1.1% in FY16. Hence, in my view, RBI’s projection of CPI inflation at 5% in FY17 appears too benign, especially with the government focusing on boosting consumption to revive demand.

RBI’s projection on growth for FY17 is kept unchanged at 7.6%, little better than 7.4% in FY16. This is pivoted on normal monsoon, consumption boost from the pay commission, OROP and accommodative monetary policy. These factors overweigh the downdraft arising from fading impact of lower commodity prices on gross value added (GVA), corporate sector stress, weak global growth and tight credit standards of banks.

The convergence of RBI’s countercyclical expansionary approach with the fiscal stance of the Union and state governments is ahead of completion of cyclical and structural adjustments necessary for enduring growth recovery. For instance, the declining trend in term-deposit growth since FY09 to a 52-year low of 9.5% recently along with a surge in retail lending growth to 18% indicate a continued decline in the financial savings rate, which has been a big drag on domestic investments, and possibly the reason why the banking system has experienced persistent liquidity deficit over most of past five years. RBI’s new framework of liquidity management or transmission of lower rates may not be helpful in this regard.

Also while RBI’s enthusiasm with OMO purchases can possibly bring down investment (G-sec)/deposit ratio of banks by a 100 basis points from the current 29%, with the recent upsurge in banks credit/deposit ratio to 77%, close to the 2014 peak of 78%, it will mean that the overall allocation of banks across credit, government securities and cash is still around 110% of deposits, implying possible persistence of liquidity shortfall.

Hence, spillover effects of higher inflation and widening external deficit will quickly relapse along with the short-term positive multiplier effect of expansionary policies on demand. It is also important to note that RBI governor Raghuram Rajan has overlooked his recent cautionary view that stimulus-led approach has little multiplier effect and as experiences of 2010-11 indicate, the follow-up repercussion of higher inflation and lower growth does not help improve the debt dynamics.

Whether RBI is able to address the liquidity deficit meaningfully will depend on the movement in forex flows, transaction demand for money, strength in credit growth rising and sustenance of credit-deposit wedge.

The sustainability of RBI’s current approach will be challenged if inflation turns out to be higher than 5% (say 6-6.5%), INR/USD relapses into depreciation and credit demand outpaces deposit growth, thereby sustaining the liquidity deficit.

Dhananjay Sinha is head of institutional research, economist and strategist at Emkay Global Financial Services Ltd.

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