Photo: Mint
Photo: Mint

Opinion | Budget less of a worry; inflation, liquidity matter

There’s concern that any sign of withdrawing liquidity could be construed as tightening

Revised estimates for FY20 budget math showed that the additional fiscal headroom, owing to the escape clause under the Fiscal Responsibility and Budget Management (FRBM) Act, helped the government offset the shortfall in revenues, rather than make room for heavy spending. This leaves the delay in fiscal consolidation a less of a worry for the monetary policy.

As the Reserve Bank of India (RBI) monetary policy committee meets this week, attention will be on the inflation trajectory and liquidity as a conduit to transmission.

Markets are keen to gauge the central bank’s assessment of the spurt in December 2019 inflation, which tested past the upper bound of the inflation target band of 6%. Low base effects will keep January’s close to 7%, even as sequential trends (on lower food and fuel) have moderated. This leaves 4QFY19 and 1QFY20 (i.e. 2HFY20) inflation above RBI’s projections and an upward revision in 2HFY20 and 1HFY21 forecasts to ~6% and 5% is likely.

Pricing curves reflect jitters on the policy direction. Swaps have squeezed out the likelihood of further easing, while scrutinizing policy commentary for forward-looking signals. Is a shift to a neutral policy stance in the offing? We suspect not.

Price pressures are evident primarily in vegetables, but also the broader food basket, including pulses and other proteins. From a deflationary phase, pulses have drifted up (y-o-y), which along with supply disruptions might be influenced by the cobweb phenomenon, wherein cropping patterns change due to prolonged low/high return on crops. Global food prices are also up. Price increases in telecom, medicines, steel and cement, etc., add to the mix.

Nonetheless, this is still a predominantly supply story. And the situation is improving. Vegetable prices are off the boil (onions -30% m-o-m, selected pulses down m-o-m) as supplies were restored. A further correction here could take inflation towards 5% in a couple of months. The Australian weather bureau expects rainfall conditions to be neutral, ahead of the southwest monsoon.

Juxtaposing retail inflation to falling rural wage growth—real and nominal—reinforce the absence of demand catalysts, as does the significant negative output gap. Better returns on food could improve the unfavourable rural terms of trade (food to non-food), but eat into urban spending, keeping the demand dynamics unchanged.

While the central bank does not explicitly target core inflation, it will be factored in as an indicator of weak demand indicator in their price models, weakening the justification for a shift to neutral bias.

Consequences of any such early change in stance could be damaging. For a start, it will be interpreted as a precursor to a tighter rate environment, lifting money market/short-end rates for a start. This be a wash-out for the policy transmission agenda, including neutralizing Operation Twist efforts. Higher borrowing costs spell trouble for firms and companies, which are still in midst of deleveraging, adding to pipeline risk for banks’ and non-banks’ balance sheets.

Add to this, a premature shift will leave the debt securities unattractive for portfolio investors, just as market access is being improved.

Keeping liquidity in surplus to facilitate policy transmission is the other key policy prerogative. The banking system liquidity is at a strong surplus of 3 trillion as the central bank steers clear of liquidity mopping operations, while regular FX intervention to mop up dollar flows adds to rupee liquidity. The call weighted average rate is hovering below the policy repo rate. Add to this strong offshore borrowings by companies (up 50% y-o-y in April-November 2019), in addition to heavy government expenditure.

While such excess rupee liquidity could stoke asset price inflation worries, RBI appears to be willing to tolerate this surfeit. There is rightful concern that any sign of withdrawing liquidity could be construed as tightening (like the argument above for neutral stance).

With inflation coming off the boil, we suspect that surplus liquidity will prevail for longer than past cycles. For now, as credit growth remains lacklustre, much of this excess with banks is making its way into government securities, even as the statutory liquidity ratio heads to an all-time low of 18%.

Radhika Rao is economist at DBS Bank.

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