RBI May Not Cut Rate Now, Action Likely In December

India’s central bank is under pressure for a cut in its repo rate. The provocation is a sudden slump in the economic growth in the June quarter to a three-year low 5.7% (from 6.1% in the March quarter), continuing with the slide for five successive quarters.

Traditionally, everyone expects the Reserve Bank of India (RBI) to do much of the heavy lifting when economic growth is slowing and a cut in policy rate is perceived to be the most potent tool for achieving this goal.

The situation at this juncture is a bit tricky. The Indian central bank has given up its job of multitasking in terms of supporting economic growth, fighting inflation, managing liquidity and the local currency, and, of course, financial stability—all at the same time. By an Act of Parliament, it is now an inflation-targeter central bank.

Can it give up that role, and can growth take precedence over inflation fighting, particularly when almost every analyst has gone back to the drawing board and raised their year-end inflation projection by 25-50 basis points on account of various factors? One basis point is 0.01%.

Barring our concern for growth, there is nothing in the macroeconomic scenario as well as external sector which can call for an RBI rate cut at this juncture.

Is the best behind us?

On the macroeconomic front, the best is probably behind us. Inflation has bottomed out, current account deficit has been widening (at 2.38% of GDP in the June quarter it is at its four-year high), there is uncertainty whether the government will decide in favour of a fiscal stimulus (this means overshooting its fiscal deficit target 3.2% of GDP for the current fiscal year), and the rupee has started depreciating. While the recent slippage in local currency should make RBI happy, there is no other good news.

The rupee breached the 65.75 level to a dollar last week, its six-month low. After buying heavily Indian equities for three successive months between May and July, foreign institutional investors (FIIs) sold $1.7 billion in August and another $1.1 billion till 27 September. In the debt segment, however, they have remained net buyers since February, pumping in at least $20 billion so far this year. With over $402 billion in its foreign exchange reserves kitty and another $30 billion in its forward dollar book, RBI should not be worried about the depreciation of the rupee.

The local currency is overvalued vis-a-vis dollar. Had FIIs continued their equity buying, RBI would not have stopped buying dollars from the market to stem the rupee appreciation and that would have increased the liquidity in the system. For every dollar the central bank buys, an equivalent amount of rupee flows in to the system. At the second stage, it sterilizes the money by selling bonds under the so-called open market borrowings or OMOs. Till last week, RBI has sucked out Rs60,000 crore through OMOs.

The average surplus daily liquidity in the system which was at least Rs3 trillion till August has almost halved in the second half of September. There are many contributing factors—RBI’s absence in the foreign exchange market as a buyer of dollars at this point, continuous OMOs, a slight rise in demand for working capital loans by certain industrial units, particularly the exporters, which are facing cash flow problems because of delay in refund of goods and services tax, and the advance tax outflow.

No more OMOs?

As the government starts spending, liquidity will rise but that will be neutralized over the next one month with more money in the hands of public during the festival season. RBI may not have to do OMOs to drain liquidity in the second half of the fiscal year.

Overhang of liquidity may not be an issue in the second half of the fiscal year. What about the policy rate? RBI deputy governor Viral Acharya, who is in charge of monetary policy, once said the central bank is comfortable with around 1.75% real interest rate. The anchor for the real rate is one-year treasury bill. Since the one-year treasury bill yield is now 6.25%, and RBI sees the year-end inflation at around 4.5%, there is no reason to change the policy rate.

Of course, one can always argue that RBI has a “flexible” inflation target. Since the objective is to keep the inflation at 4% +/- 2%, inflation now and even if it rises beyond the RBI projection, should not come on the way of cutting the policy rate. However, after announcing that it wants to contain inflation at 4%, unless there is a compelling reason, if RBI cuts the rate, it runs the risk of losing credibility.

For the time being, it should refrain from cutting the rate. There are two reasons behind this: One, uncertainty over the outlook on inflation and, two, the lack of clarity over the nature of the economic slowdown in the June quarter.

Inflation may overshoot projection

Retail inflation, which slowed to 1.46% in June, quickened to 3.36% in August and the so-called core inflation, or the non-food, non-oil manufacturing inflation, even after excluding transportation and housing costs accelerated to 4.3%. No one is sure about the claim by many that we have broken the back of food inflation by structural changes. In fact, analysts are saying that higher domestic fuel prices will more than offset lower vegetable prices even as the core inflation remains sticky. Keeping in mind the below-normal and unequal distribution of monsoon, rise in global commodity and food prices, increase in housing rent for central government employees and uncertainties surrounding the implementation of goods and services tax (GST), most research houses which were pencilling 4-4.5% year-end inflation projection till recently, have raised their projection to 4.25%-4.75% and even 4.5%-5%. In the last monetary policy in August, RBI outlined its inflation expectation by the year end at around 4%.

On the growth slowdown, the jury is still out on whether it is structural or transient or a combination of both (a long-term slowdown and temporary shock factors like demonetization and the manufacturing destocking ahead of GST).

The ideal thing for a central bank to do at this juncture is wait and watch for more data. The next policy in December could be the right platform to announce a rate cut if the incremental data convince RBI.

More data will flow by December

Before the December meeting of the monetary policy committee, it will have on the table the inflation figures of two more months—September and October. By that time, the September quarter growth figure will also be known. More clarity will also emerge on the impact of GST on various sectors. Besides, RBI will also get a hang of the impact of the latest round of “taper” of the US Federal Reserve on the market and currency.

The US Fed left its policy rates unchanged in September but most analysts expect one rate increase by the end of the year even as the Fed starts unwinding in October to reduce its $4.2 trillion in holdings of US Treasury bonds and mortgage-backed securities by paring it up to $10 billion each month. The European Central Bank too is expected to wind down its stimulus efforts, beginning next year even as the Bank of England may raise its benchmark lending rate in November for the first time in more than a decade.

If the September quarter growth figure is worse than the June quarter, then RBI can cut the rate even if it is not comfortable with the inflation trajectory. To prepare the market for that, should it change its stance from neutral to accommodative on 4 October? There’s no need for that as a neutral stance gives it the flexibility for going in either direction. The Bank of Indonesia cut its policy rate for the second consecutive month in September despite holding a neutral stance. South-East Asia’s biggest economy has been trying hard to lift the economic growth rate, which has remained around 5% for past one year.

Cut in GVA forecast?

On 4 October, RBI can keep the 6% repo rate on hold, lower its gross value added or GVA forecast for fiscal 2018 from 7.3% (could be as much as 75 basis points) and say future action will depend on incoming data. A December rate cut probability is higher—provided the data support that—as it will be difficult for RBI to go for a rate cut next year since the government may opt for a fiscal stimulus in the last quarter of current fiscal year if the slowdown continues and compromise on the fiscal deficit target. The fiscal health of Indian states is no good. And, keeping in mind the 2019 general elections, none expects the next budget to the fiscally prudent. In 2016 and 2017, Indian economy rode on the crash in oil and metal prices. The good days are over. We need to find new levers of growth. GST could be one of them, if it is implemented efficiently. For the time being, the teething troubles have added to the problem.

This column first appeared in www.livemint.com

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Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of A Bank for the Buck, Sahara: The Untold Story and Bandhan: The Making of a Bank.

His Twitter handle is @tamalbandyo.