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The Monetary Policy Committee (MPC) raised repo rate by 50 basis points to 5.4%, while continuing with its stance of “withdrawal of accommodation". What was different in this policy from the previous policy, was the focus on the external sector as laid out by the Reserve Bank of India governor in his opening statement and during post-policy discussions. It is under immense scrutiny because of foreign portfolio investor (FPI) outflows aggregating to $35 billion since October 2021, and ever-rising trade deficit which increased to $31 billion in July, the highest on-record. So, how do we see growth, inflation and interest rates from here?

With the 50bps rate hike, MPC has now raised interest rates by 180bps, including the 40 bps move due to the operating rate moving from reverse repo to repo in April. If anything, RBI is doing its best to soft land the economy by undertaking a calibrated approach compared with the US Fed, which has raised interest rates by 225bps this year, and is expected to deliver another 100bps rate hike through the remaining part of the year.

The RBI governor drew comfort from India’s growth trajectory, seen in the robust revival of the services sector, rising consumption in the form of non-oil, non-gold imports, and increasing public capex and capacity utilization. With a projected growth rate of 7.2% for FY23, India will be the fastest growing large economy. Rural demand is also expected to improve with a normal monsoon and better terms-of-trade for the farm sector. In a world of constant growth mark-downs , India has been resilient, which is positive for attracting global capital.

On the inflation front, too, global commodity prices have eased from where they were at the time of the last policy. For instance, crude oil is down by more than 10% in July over June, while global metal prices have fallen by 18% since the last policy. Even so, the central bank has kept its inflation forecast at 6.7% (oil at $105 per barrel), citing elevated core inflation as a worry and uncertainty around global and domestic food inflation (considering that rice sowing is lagging).

While India’s growth momentum is far better placed than other large economies and inflation outlook is also looking better, the RBI governor outlined India’s external position by citing improvement in external debt-to-GDP (gross domestic product) ratio, reduction in net claims of non-residents and lower debt service ratio. RBI said current account deficit is sustainable at current levels, given growth should induce inflows as seen in the net foreign direct investment inflows rising to $13.6billion in Q1FY23, which is $2 billion higher than last year. Even FPI outflows turned into marginal inflows in July, and the momentum is continuing in August as well.

However, India’s current account deficit (CAD) is likely to increase to 3.5% of GDP in FY23, or an absolute level of 120 billion on the back of weakening external demand and buoyant domestic demand. RBI has enough and more reserves to finance the elevated deficit this year, and has already drawn on its forex reserves of $33billion and forward cover of $31 billion. The fall in international commodity prices, in particular energy prices, and lower domestic demand next year should ensure a lower glide path for CAD.

The interventions to reduce volatility in the foreign exchange market is also playing out in the money markets through the reduction in liquidity surplus from a high of 7.24 trillion as on 1 April to 2.07 trillion on 4 August. Because of the steady decline in liquidity surplus, weighted average call rate has actually increased in-line with the lower end of the rate corridor, which has increased by 180bps since the April policy. Considering elevated trade deficits in the near-term, we believe RBI will continue to intervene in the foreign exchange market, implying further reduction in liquidity along with other drivers of reduction in liquidity. Higher short-end rates give the right signal to foreign exchange participants and RBI will provide need-based liquidity.

In view of the above backdrop, we believe RBI is going to continue its rate hiking cycle in tandem with global central banks. It will serve its objectives well since higher interest rates will reduce aggregate demand and implies lower CAD, and also ensure there is no untoward pressure on currency when global interest rates are moving higher. We continue to believe that RBI will raise terminal repo rate to 6% over the next two policies, and can then pause to reassess growth and inflation dynamics.

The writer is head of Global Markets, ICICI Bank..

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