An analysis on macros into midterm review of monetary policy

Structural dynamics

·       There is lack of confidence (from both domestic and external stake holders) on the political system to roll-out reforms (relating to attracting off-shore investments; tax reforms; land reforms; labour reforms etc) and address fiscal consolidation. There is no political consensus to move forward and Congress Party is struggling to get support from within and outside UPA on case-to-case basis

·       The economic scenario is at risk of stagflation; GDP growth below 6% and inflation above 6%. The domestic contribution to GDP is steady but no clear signs of support from external sector

·       The monetary scenario is not growth supportive; deficit liquidity with Rs.1 Trillion draw-down from LAF and overnight MIBOR at higher end of LAF corridor, the Repo rate. RBI’s hawkish stance on monetary policy has guided downtrend in headline (and core) inflation but has hurt growth.

·       Current Account deficit (CAD) and Balance of Payment (BOP) is under severe strain. The need is to address imports and ensure steady flows into capital account while the system awaits improvement in western economies to build exports. Government and RBI (and Government) should look at cutting non-essential imports and increase domestic production on essential imports to have permanent solution to CAD and stay less dependent on external flows. CAD is higher at 4% of GDP and negative BOP has already exerted pressure on the exchange rate with rupee sharply down by 30% since July 2012 (from 44 to 56)

Growth-inflation dynamics

·       FY12 GDP growth has slipped from 8% in Q1FY12 to 5.3% in Q4FY12; sharp slippage against end FY12 estimate of 7.6%. There is across-the-board pessimism on expectation for FY13; most stake holders estimate GDP growth for FY13 at below 6% as against Governments estimate of 7.1% for FY13. There is no improvement in the external sector and the need is to ramp up domestic contribution to GDP. There is immediate need for RBI and Government to focus on growth through (a) attracting off-shore liquidity and capital; (b) attract domestic investments; (c) increase domestic consumer demand; (d) enhance domestic capacity; (e) increase public investments on core sectors and (f) higher focus on agriculture, infrastructure and natural resources

·       FY12 headline WPI inflation has slipped from near 10% in Q1FY12 to 7.5% in Q4FY12. There is comfort from sharp slippage in core inflation (at 4.8% for May 2013) while food and fuel prices stay at elevated levels. RBI has no role to play in managing food price inflation but there is comfort from the Government that it would moderate this number through various supply-side measures. There is optimism in fuel price inflation tracking sharp reversal in crude oil price with BRENT Crude down from $128 a barrel to below $100 a barrel. But, this benefit is completely knocked out by sharp depreciation in rupee from 44 to 56 (30% depreciation is BRENT Crude is undone by 30% depreciation in rupee; thus the landed cost of crude in rupee value is steady at elevated levels)

·       FY12 fiscal deficit at 6% of GDP is a serious concern. The market borrowing by the Government is huge. The fiscal deficit is used for consumption and not for capacity creation; thus adding burden on the future with high interest cost. Government has budgeted to limit cost subsidisation to 2% of GDP

·       RBI was considering inflation as major risk to growth and the monetary system is still in hawkish mode despite delivery of 125 bps CRR cut and 50 bps rate cut. The need is to drive system liquidity into surplus mode and shift overnight rates into lower end of LAF corridor, the Reverse Repo rate to shift the monetary system to growth supportive mode.

Trend on major indicators

·       There is severe downside risk to growth. There will not be support from external sector in FY13. Euro zone is vulnerable and US economy is showing signs of weakness with expectation of QE3 support before Q4 of CY2012. There is optimism on domestic output subject to support from the Government and RBI’s shift into growth supportive monetary stance.

·       Fuel price inflation is comfortable and sharp fall in BRENT Crude since May 2012 will get favourable reflection in pipe-line data. It is also believed that the worst is behind for rupee with low risk of rupee posting a new all-time low above 56.52. The trend for fuel price inflation is down tracking further fall in BRENT Crude price and gradual rupee appreciation to 53 during FY13

·       Food price inflation is high driven by good demand not met with adequate supplies. A good monsoon and measures from the Government to address supply side concerns will help to guide moderation in food price inflation during the course of FY13

·       The sharp fall in commodity prices will release the pressure on CAD; import bill of crude in USD terms is already down by 25% (annual benefit of USD 60-75 billion). The growth supportive monetary stance would attract off-shore investments into debt and equity market. Over all, trend in CAD and BOP is positive; considered good for exchange and interest rate

·       The trend on fiscal deficit is positive. The fuel subsidy bill will be down tracking downtrend in BRENT Crude and USD/INR. The deficit situation will improve significantly even without pass-through to consumers. If the Government choose to pass-through, its impact on inflation will be manageable

Expectations from RBI

·       It is obvious (from the above) that downside risks to growth are severe than upside risks to inflation

·       The economic and market forces which were exerting pressure on exchange rate and interest rate has shown signs of moderation and expected to shift into favourable mode during course of FY13

·       There is no risk of sovereign rating downgrade given the high confidence to manage fiscal deficit; CAD and BOP (RBI may not consider this as conflict of interest for shift into easing monetary policy)

·       The monetary supportive stance since January 2012 has not turned growth supportive (despite 125 bps CRR cut and 50 bps rate cut) as monetary dynamics are still anti-growth (deficit system liquidity and overnight rates at Repo rate)

It is a straight-forward case for RBI to inject liquidity and cut rates. The issue is on the quantum. The system liquidity is short by 150 bps of NDTL; hence there is need to cut CRR by say 50-75 bps (it will be wishful to expect one-shot cut of 100-150 bps; liquidity injection has to be in combination of CRR cut and OMO to provide stability in bond yields to keep borrowing cost of the government at low/affordable rate). This (CRR cut of 50-75 bps) may not be good enough to guide overnight rate from Repo rate to Reverse Repo rate; thus overnight rate will continue to stay above 8%. So, the action has to be in combination of CRR cut and rate cut, say by 25-50 bps. So, there are four combinations:

1.     75 bps CRR cut and 50 bps rate cut (0% probability)

2.     75 bps CRR cut and 25 bps rate cut (25% probability)

3.     50 bps CRR cut and 50 bps rate cut (50% probability)

4.     50 bps CRR cut and 25 bps rate cut (25% probability)

Moses Harding