RBI IN BALANCING ACT TO MANAGE GROWTH-INFLATION CONFLICT

The Reserve Bank of India (RBI) is yet to shift its monetary policy stance to be more supportive to growth on account of its limited bandwidth in the current low growth – high inflation scenario. One cannot say that the monetary policy stance is accommodative when overnight the call money rate is administered between Repo and MSF rate corridor, which is presently at 7.25-8.25 per cent. RBI has maintained a deficit system liquidity stance with restrictions at Repo counter on the availability of funds on excess SLR portfolio through introduction of term money Repo at premium to the Repo rate.

The recent OMO bond sale auctions conducted to suck out excess liquidity and to prevent easing in overnight rate into the LAF corridor (presently at 6.25-7.25 per cent) confirms this intent. The need to maintain this hawkish stance arises from the risk of uptrend in CPI inflation into the higher end of the set tolerance zone of 4-6 per cent. Despite the risk on CPI inflation, RBI has delivered three rate cuts in 2015 by bringing down the Repo rate from 8.0 to 7.25 per cent. One can conclude that RBI has taken a neutral position to support growth with rate cuts while retaining deficit system liquidity to control inflation.

Risk from twin deficits and rupee exchange rate stay diluted

The RBI has drawn comfort from dilution in resistive headwind impact from elevated twin deficits and downside pressure on the rupee exchange rate. There is high confidence on achieving long term fiscal prudence with fiscal deficit target in downtrend mode at 3.0-4.0 per cent of GDP on account of higher revenue and plugging of slippages. The Current Account Deficit (CAD) is sharply down from elevated levels of 4-7 per cent to 1-2 per cent of GDP, thanks to sharp reversal in commodity prices, especially Brent Crude at below USD 60 per barrel and gold below USD 1100 per ounce, both of which constitute a major chunk of imports.

It may not be a surprise if the current account turns into surplus on the back of export-led ‘Make-in-India’ theme. With CAD sharply down and off-shore inflows in plenty, the rupee has emerged as one of the stronger global currencies. But for RBI’s sterilisation of excess foreign currency supply, the rupee would have been in sharp appreciation mode into the 55-60 band. RBI’s sustained purchase of USD from the system has not only helped in the build-up of foreign currency reserves but has also resulted in infusion of rupee liquidity into the system, thereby exerting downside pressure on short term money market rates.

The combination of USD purchases made by RBI and 75 bps rate cut in 2015 has resulted in a sharp decline of short term money market rates by 1 per cent in 2015, leading to cut in lending rate by commercial Banks. On the other side, RBI’s deficit liquidity policy has pushed medium/long term yields up by ~ 50 bps. The 10Y benchmark Gilt yield rose from 7.50 per cent to 8.0 per cent, making the returns attractive to long term retail investors. Here again, RBI pursued a balancing act for bringing the lending rate down without hurting retail investors. The combination  of reduced demand for funds from  the system on account of  lower fiscal deficit, cut in permanent export of domestic capital to bridge higher CAD and dilution of  weak rupee impact on interest rate has offered  great comfort to  RBI for  staying  neutral till inflation risk goes out of the radar.

Elevated CPI and FED shift to rate hike mode is risk in play

The RBI has set a reference benchmark of 1.50-2.0 per cent spread between the CPI index and the operative policy rate,(currently the Repo rate). At present, the spread between Repo rate and June CPI is around 1.75 per cent. The risk from uptrend in CPI into the higher end of the set tolerance zone of 4-6 per cent on account of high food inflation and base effect impact provides no room to RBI for further easing of rates till such time the CPI stabilizes at the lower end of 5.0-5.5 per cent, against RBI’s January 2016 outlook of 6 per cent. The external headwind to India’s rate cut is from FED’s preparedness to start the rate hike cycle from Q4/2015. The resultant uptrend in US yields will exert downside pressure on Rupee exchange rate, which is currently at the lower end of the RBI’s comfort band of 63-67.

However, if seen against the backdrop of USD’s strength against global (and emerging market) currencies, the exchange rate risk is seen as less of a major impediment to RBI’s rate cut move than the upside risk on CPI which  could extend the next step of rate cut, beyond 2015. All combined, the way forward looks clear and there is just one major hurdle preventing a shift to dovish monetary policy stance while other irritants are out of the radar. The options ahead are - extended rate pause on CPI stability at 5.5-6.0 per cent, 25-50 bps rate cut on CPI stability at 5-5.5 per cent and shift in operating policy rate from Repo to Reverse Repo rate on CPI stability at 4-5 per cent.

What to expect from RBI on August 4 policy review?

The RBI will currently not be under pressure to deliver rate cut post the 75 basis points cut in H1/2015, in the absence of appropriate rate transmission in bank’s base rate, which has been lowered only marginally. The monetary policy agenda is to ensure smooth flow of liquidity at affordable cost to the desired sectors of the economy. It is also imperative that monetary policy actions drive consumption which in turn spurs investments for capacity expansion. The issue ahead is not the availability of liquidity but the risk averseness of investors who do not see enough viable investment opportunities and of lenders who are negative on the risk-reward trade-off on credit exposures.

Banks are already holding excess SLR investments in the range of 6-8 per cent of NDTL, which are largely funded out of deposits at zero or negative spread. This stance indicates that lenders are willing to forego interest margin in order to preserve capital.  Companies in well-performing sectors such as pharma, IT, FMCG and consumer durables are cash- rich and are able to fund their capacity expansion through internal accruals, while companies operating in the infrastructure, agriculture and core manufacturing sectors that require external funding do not fit into the investment profile of the investors.

The RBI could do very little to ensure flow of monies to these core sectors which are critical for driving economic growth,  despite giving priority sector status, statutory exemption and tax relief, covering both sources and uses of funds. The cost of funds is low for good credit but is very high for those entities that are either highly leveraged or have weak balance sheet. All combined, a rate cut at the moment is not going to emerge as a catalyst for accelerating growth. It could only benefit good risk borrowers at the cost of cash rich investors. Against this backdrop, RBI is expected to stay in pause mode, while awaiting monsoon impact on food prices and base effect impact on CPI which could push September to December CPI into the higher end of 5.5-6.0 per cent. The best case therefore would be  to expect  status quo on policy rates, CRR and SLR  and hope for a rate cut in Q4/2015 when there is  better clarity on 2016 CPI trend. It is positive for the economy that external cues continue to stay favourable for CPI from lower Brent Crude at $45-60 per barrel and more than adequate liquidity flow, while the worst is behind us on domestic cues. The rate pause on August 4 should not come as an unpleasant surprise while remaining hopeful of a 25-50 bps rate cut in H2/FY16.