RBI Credit Policy – Should we expect a rate cut in August?

Come August and the topic once again veers around to the forthcoming bi-monthly monetary review. Will there be a rate cut; seems to be the overriding question. Many of the macros are, interestingly, supporting a rate cut. But the rate cut decision in August may hinge on factors outside of macros. Let me explain!

To begin, macros are favorable…

Inflation is well in control around the 5% mark. The biggest X-factor was the monsoon rainfall. While early July was a fairly dry spell, the deficit seems to have been made up in late July. At the end of the Monsoon, the overall deficit is unlikely to be higher than 6-7%. Secondly, Q1 results have been fairly disappointing and the pressure on operating profits is quite visible. This may again make the case for a rate cut. With major banks starting to pass on rate cuts to the end customer, the RBI cannot really say that transmission is not happening. So, what now?

It is all about the US Fed…

This will be the basic consideration for the RBI when it decides on rate cuts this August. The US employment and growth data is pointing towards the first rate hike in September. A rate hike in the US will have the effect of reversing flows from emerging markets into the US. This can have a deep impact on debt inflows, which constitutes a much larger chunk of India’s portfolio inflows in the last couple of years. A rate cut will have a dual impact. Firstly, a rate cut will have the effect of diverting a lot of safe haven money back to the US. Secondly, FIIs holding government securities in India may want to book out from India and reallocate. With a forex reserve level of $355 billion, the external situation is just about comfortable. Like the RBI learnt in 2013, it cannot experiment with portfolio inflows, which predominantly fund the fiscal deficit.

IFC 2015 raises questions…

Another big question before the RBI will be what will be its role once the Indian Financial Code (IFC) 2015 becomes a reality. It may be some time away but it calls for sweeping changes. For starters, the RBI governor loses his veto power over key macro variable setting. Secondly, the RBI will cede substantial powers in the monetary stance to the MPC, which will be dominated by government representatives. Thirdly, with the debt management likely to be taken outside the purview of RBI, they will not be too sure of their influence in setting rates.

In a nutshell, though macros are favorable, we may not see a rate cut in August. The uncertainties over the US Fed and the IFC 2015 will dissuade RBI from sticking its neck out on interest rates. For the rate doves, they may have to wait longer for “Achhe Din”. ©

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