fix twin deficit for accomodative monetary policy

Fix twin-deficit for growth supportive monetary policy

The message seems to be loud and clear; all ex-Central Bankers have joined the Governor (of RBI) to send clear signals to the Government to fix issues related to fiscal deficit and Balance of Payment to get RBI into growth supportive rescue act through accommodative monetary policy. It is obvious that high fiscal deficit and weak (and volatile) exchange rate are the main causes for conflicts in growth-inflation dynamics. RBI has now made its stance very clear that it may not be in the interest of the economy (over medium/long term) to take accommodative monetary policy stance when headline inflation is high and inflation adjusted effective interest rate is low. It may be harmful to trigger demand push inflation when supply side concerns persist. It may also lead to low savings (and investments) and emerge as major risk to growth.  The take-away is that the economy should be prepared for moderation in growth momentum (at below 6%) while efforts are taken to guide headline inflation into RBI’s comfort level of below 5%.

The near term outlook on inflation and exchange rate is bearish. The roll-out of higher Minimum Support Price (for agriculture produce) and not-so-good monsoon will exert upward pressure on food price inflation. The pass-through of cost subsidisation in diesel, kerosene and cooking gas will have its impact on fuel price inflation. The weak USD against major currencies has provided sharp reversal in Crude Oil prices; it is already up by over 15% from its recent low. Rupee is also unable to hold on to its gains below 54.30 and has seen sharp reversal from 54.17 to above 55.30. There is also risk of widening Current Account Deficit due to uptrend in commodity prices; reduced exports and impact from poor monsoon with the need to cut export of food grains and import other essential food items. Taking all these together, it is easy to conclude that inflationary expectations will remain weak into the near/short term and it may be impossible for RBI to get into accommodative monetary policy stance soon.

There will be no surprise in the Presidential election but what is relevant for the stake holders is the time to act in addressing pipe-line issues and resolutions thereof. The market has already priced-in roll-back of contentious tax related issues, fuel price hike and FDI expansion. It is important for the Government to cut the lag time between election of new President and delivery of these expectations; time-delay beyond 31^st July will be bad for asset markets. It will be disappointment for RBI if nothing is done by the Government before its Quarterly policy review on 31^st July. So, the attention is on the Prime Minister (and his Government) to get directional guidance for asset markets.

What is the way forward? There is now consensus that RBI may not get into rate cut action till inflationary expectations turn positive and actions from the Government to fix twin deficit. Given this stance, RBI will also maintain system liquidity at deficit mode above its tolerance level of 1% of NDTL to arrest impact of liquidity on interest rates. Therefore, operative policy rate will be maintained at 8% for now. There may not be significant impact on Money Markets on this move as delivery to expectations will maintain price stability with 10Y Bond yield in consolidation mode at 8.0-8.15%. There will be need for OMOs to prevent weakness beyond 8.15% when net supply of bonds will be at its peak in August-September with severe pressure on liquidity during this period. There will be upward pressure on shorter end of the curve with stability in the medium/longer end, thus causing expansion in inversion of the tenor spread. The impact on interest rate from exchange rate stands diluted now. The worst for rupee is seen to be behind; strong headwinds from external cues may turn supportive to provide momentum for rupee gains. At this stage, it is safe to assume that India Sovereign rating is not at risk and outlook may turn positive soon. The weak Euro and US zone and resultant loose monetary policy will drive off-shore liquidity into India’s debt and equity capital market to bridge Current Account deficit and keep Balance of Payment positive. While it is in order to look for rupee stability at 53-56, chances of move into 53 is high which will keep forward market in supply driven mode to cut FX impact on rupee interest rates. Over all, there may not be excessive and undue volatility in both interest and exchange rate market. Given these expectations in Money and Foreign Exchange market and support from off-shore investors, Indian Stock market will stay neutral to mildly bullish into near/short term. The range to look for NIFTY is at 5100-5600 with bias into higher end while weakness below 5100 will be good value buying for strategic investors. The recent relief rally triggered by build-up of “hope” is losing steam and it is time to deliver and act decisively to convert relief rally into bullish trend.

Moses Harding

Head – ALCO and Economic & Market Research

IndusInd Bank, Mumbai