There was not a great element of surprise in the policy announcement as the RBI decided to maintain status quo. That was largely expected. While the language of the RBI has been largely accommodative, it has some immediate concerns on the macroeconomic front. Also there is the overhang of the critical Fed meet coming up in March, where the world is watching if the FOMC chooses to hike rates by 25 bps or not. It will be interesting because even while the US has been talking hawkish, the ECB has gone ahead and announced lose money policies while the Bank of Japan has actually gone ahead and taken interest rates to negative territory. How the Fed handles this monetary divergence will be interesting to see.
There is also a very sharp inflation argument that is weighing on the RBI right now. The Rabi season has shown some weakness in output largely due to deficient rainfall. This will weigh on food prices. Secondly, the CPI inflation at 5.6% has shown a rising trend for 4 months. The RBI will be keen to see if the base effect starts playing in the coming months and pulls inflation down. This will be a critical input when it comes to deciding on rates. Let us look at the highlights of the policy announcement:
Highlights of the Credit Policy announcement…
- The critical signal, Repo Rate, has been left unchanged at the level of 6.75%.
- As a result the reverse repo rate stays at 5.75% (repo – 1) and the bank rate stays constant at 7.75% (repo + 1).
- The RBI has chosen not to make any changes to the Cash Reserve Ratio (CRR) and has maintained it at 4%.
- The RBI will continue to use variable rate repos and reverse repos to smoothen the liquidity in the system.
The outlook is based on Inflation and Union Budget…
The RBI review of the Indian economy has focused on the weak agricultural growth and industrial numbers in the third quarter. Also, within the services space, the construction activity has been tepid. This has led to the economy losing its spill-over effect of growth. With massive payouts in the form of OROP and the Seventh Pay Commission payouts, the RBI is expecting pressure on inflation and on fiscal deficit. The RBI would want to avoid a situation where the inflation shoots up and rates are cut, leaving the Indian economy in a situation of low real interest rates. That could be negative for debt flows. The lessons of 2013 are still fresh in the minds of the RBI and that will weigh on the RBI policies going ahead, to avoid the rupee carnage of 2013.
The Union Budget is another area of import for the RBI. The government could be planning a major thrust for the banks in terms of recapitalization and in letting them manage their NPAs better. That would be something the RBI would watch out for as it would help transmission of rate cuts in a seamless manner. The RBI will also watch out for the fiscal deficit expectations of the government and most likely it is set to spill over on the higher side. That could have implications for the INR and the RBI will be keenly watching out for that.
What the Fed will do is also critical…
The RBI will also focus on what the Fed will do in the March policy. There is already a strong expectation that the Fed may choose to hold rates in March to avoid too much monetary divergence. That would mean less chances of a rate cut by the RBI. The Fed move will largely determine the flow of capital. We saw the reaction of global markets to the 25 basis points cut in December as global markets went into a free fall in January. With the slowdown in China and real risk of devaluation to the rupee, the RBI will be very cautious to ensure that capital flows do not reverse for the INR.
The growth versus rates riddle…
What the RBI needs to address is the growth versus rates riddle. The slowdown in the economy is evident. Exports have fallen for 14 months in succession and GDP growth is likely to end up at around 7.2%. That is nearly 130 bps lower than the original estimates. The easiest way to prop up the economy would be to aggressively cut rates. But that would be negated by two factors viz. Capital outflows and High inflation. That is why the RBI has adopted the wait and watch approach.
The RBI presents its next policy on April 05th. By then there will be clarity on the US rates move and also on the inflation front. That will give the RBI a better base to take a call on rates. The Union Budget will also be a critical input. The fiscal deficit guidance will be closely watched and it is already expected that it could spill on the upside. That is negative for the INR. Also the government is expected to announce some big bang reforms for banks covering recapitalization and NPA management. If these two issues are addressed, the problem of poor transmission of rate cuts will automatically be solved. This combination of factors could spur the RBI to cut rates when it meets next in April. But till then it will be wait and watch!