The RBI policy announced on 06th Feb had little by way of surprises. The RBI held on to its repo rate of 5.15% leaving the reverse repo at 4.90% and the MSF and bank rate at 5.40%. What were the key drivers for this status quo?
Inflation was the key reason
Clearly inflation at 7.35% was hardly conducive to cutting rates. At current levels of inflation, the real return was already negative and there was no way the RBI could have slashed repo rates any further. Also, inflation expectations hinted at further uptick in household inflation expectations. The RBI also realized that the repo rates were at 15-year lows and with such high inflation there was no way to cut rates. Lower rates would have fueled inflation via credit binge and the RBI could not afford to take the risk.
Letting fiscal policy play out
One of the underlying themes of RBI policy in the recent past has been to let fiscal policy take over. With rates having been cut by 135 bps last year and only partial transmission done, this was the logical step. The Budget announced on February 01st has made some changes to the tax structure with a view to put more money in the hands of the lower and middle income class. The argument is that this would be more instrumental in fuelling growth in GDP rather than interest rate cuts. That is the key!
Waiting for transmission
One of the arguments in favor of status quo on rates was that the transmission to the end borrower had to still fully play out. For example, in the case of the weighted average loan rates (WALR), the average transmission was still less than 50%. However, shift to external benchmarking of floating rate loans only began in October and since then the progress on transmission has been quite rapid. The RBI also thought that it would be opportune to let these trends play out fully and the transmission get to above 75% before further rate cuts. One of the measures in the policy to ensure adequate liquidity was essentially aimed to ensure seamless transmission.
Portfolio flow angle
There is an important external angle, which most policymakers do not talk about openly. A cut in rates normally tends to weaken the rupee and make Indian debt unattractive to FPIs. Both these factors are negative for FPI flows. The reason Indian debt was attracting massive foreign flows was that the real returns offered in India were as high as 4% till last year. This year that return has turned negative because of lower yields and specifically because of higher inflation. RBI was apprehensive that any further dovishness would make the foreign bond investors jittery and they could exit; creating a cascading effect. That is something best avoided! ©