Weak inflation and growth but rate cuts look unlikely…

The monthly macro data announced in July actually mixed. Inflation came in lower than expectation at 1.54%. This was largely driven by food inflation coming in negative at -2.12%. The real disappointment was the IIP growth for the month of May, which was just about 1.7%. In the case of IIP, it was manufacturing that put pressure on the overall IIP growth. The bigger question that follows logically is whether this could be a trigger for a rate cut? Here are some key reasons why there may not be a rate cut in the August policy despite the inflation data and the IIP data making a strong case for a rate cut.

Why the RBI may not be too keen to cut rates despite macro cues…

  • The CPI inflation at 1.54% was largely driven by food inflation at -2.12%. Within the gamut of food inflation it was pulses and vegetables that contributed with high levels of negative inflation. While this has been the case for over 7 months now, it is really questionable if this negative inflation will be sustainable.
  • The last year saw a sharp fall in pulses prices due to oversupply in the markets after a record output of pulses. With MSP levels that were not remunerative, the farmers had no choice but to dispose their produce at the wholesale markets even if it meant disposing off at a level that entailed a loss. That could change with the government already announcing a higher MSP for pulses. With a record pulses output again likely this year on the back of a good monsoon, the government could also permit free export of pulses giving a push to prices. That means the negative inflation impact on food may peter out in the next few months.
  • Then there is the aspect of non-food inflation. This is largely driven by oil prices. While oil and fuel have a small weightage in the overall CPI inflation, oil does have a strong externality. Hence, its impact will be much more serious and acute than the original weightage. While oil prices have been under $50/bbl, any temporary disruptions can take the price of Brent Crude closer to $55 and that could have a negative impact via imported inflation.
  • Then there is the all important aspect of the GST implementation. Globally, the experience has been that GST is likely to be inflationary in the first few years. That is because GST is a consumption tax and hence price changes tend to get reflected without any lag effect. The government and the RBI would prefer to watch out the trajectory of the GST before taking a call on rate cuts.
  • Then we turn to the aspect of IIP. In the first meeting of the Monetary Policy Committee (MPC) in October 2016, the decision to cut rates was taken to give a boost to weak IIP growth. However, subsequently there was the demonetization that was undertaken in November 2016 and that led to a surge in deposits with the banking system. As result banks were left with a mismatch wherein the additional deposit base of Rs.4 trillion had to be serviced but loan growth was not picking up. Hence banks were forced to cut their lending rates by as much as 90 basis points. That means the transmission of the entire series of rate cuts since January 2015 has already been achieved.
  • The big drag on IIP has been the manufacturing sector. That is happening for one reason. Indian companies are sitting on excess capacity. According to CMIE estimates, Indian industry is still operating at around 70% capacity utilization. That means industry can expand output for few more quarters without requiring any further investment.
  • But what about working capital? Indian debt markets have become the primary source of raising funds for Indian companies. The corporate bond market has become robust and CPs has become the principal source of short term borrowing in the current context. As a result, even though banks are constrained by NPAs and cannot lend, industry continues to get its share of credit from the secondary debt markets.
  • The next point is that of the level of NPAs in the banking system. According to conservative estimates, the Indian banking sector is sitting on $80 billion of NPAs and another $90 billion is in the form of stressed assets which could potentially become NPAs. Unless this problem is resolved through the current IBC mechanism, banks cannot really expand their loan book. That essentially negates the argument of cutting rates for the same of boosting IIP growth.
  • Lastly, there is the all important aspect of what the Fed and other central banks will do. The Fed has already guided for one more rate hike this year and three more rate hikes next year. Other central banks like BOJ and ECB have also called a bottom to their rate cut syndrome. That means rates could gradually move higher and the bond portfolios of central banks could be unwound. RBI would prefer to wait and watch for greater clarity on this front.

The RBI may see more value in considering rate cut in October rather than August. By the there will be more data points on inflation and IIP as well as a clearer picture on the monsoon and the impact of GST. Global rates scenario will also get clearer. But first, the RBI will have to shift its stance of monetary policy back from Neutral to Accommodative. That will be the key cue to watch out for in the August meeting of the RBI.

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