The market opinion is divided on RBI's monetary policy action on 2nd December; there is pent-up expectation (and pressure) on RBI both from domestic cues and external environment to cut policy rates, while some see sense in status-quo till confirmation on critical factors, and to avoid abrupt reversal in stance as witnessed in 2013. Obviously, things are much better now in terms of stakeholders sentiment on the Indian economy and improved macroeconomic fundamentals. Let us take an overview on factors that would impact RBI's decision - to deliver to the gallery with rate cut or stay neutral till end of FY15:
Liquidity and cost of funds not seen as hindrance to growth:
The system liquidity is in plenty and cost (and return) of funds is low. The need at this stage is not to boost demand, but is from supply squeeze with not enough investor (and lender) appetite to use (or expand) capacity. RBI continue to see current demand-supply dynamics as inflationary, given the consumption appetite even at current cost of liquidity. The belief is that demand-push easy monetary stance without adequate measures to expand supply will lead to higher inflation, which in turn will affect long term growth prospects! The theory of rate cut to spur growth momentum is not seen to be relevant when domestic liquidity is in plenty and RBI adds to system liquidity absorbing excessive off-shore inflows. RBI also believes in providing decent inflation adjusted returns to retail investors on their savings for the future. All taken, there is no prudence to cut rates now to benefit the wholesale borrowers at the cost of hurting retail investors.
Need some more time to get long term comfort on inflation:
Worst is behind on inflation, thanks to sharp reversal in imported commodity prices and base effect; while luck factor has favoured the system, there are not enough efforts to redress the structural impact on inflation from supply-side and price-stability of essential items that affects the major population. While there is great relief from sharp downtrend in CPI below 6% and WPI below 3%, sustainability at lower levels into long term is still in doubt, if the luck factor turns otherwise when base effect turns against! The concern is also from subsidy pass through impact on essential items if price benefit factors do not stay valid over long term. All taken, an autonomous RBI will not opt to jump the gun to bite the bullet now, given the lack of confidence on price-stability and sustainability of inflation at current comfortable levels.
Concerns on inflation from twin-deficits is not yet resolved:
Worst is seen to be behind on Current Account Deficit (CAD) and fiscal deficit, but desirable long term comfort is still work in progress with serious risks still in play. The relief on CAD is not driven by structural cues of higher exports and lower imports or from accelerated exports. The benefit is from combination of external luck factor (lower commodity prices) and administrative strictures (restricted gold imports). The funding of currency deficit is largely from hot-money, short-term, volatile and fair-weather inflows and not yet from stable, long term FDI flows. It is not prudent to ease rates now which would trigger reverse flow of hot-money FII funds to avoid repeat of run on Rupee seen in 2013. Combination of rate cut against weak Rupee is zero-sum game! It is long way to go to achieve fiscal prudence, given the carry-over impact of previous years. It is believed that fiscal deficit at 4% is heavily dressed up and funded through mix of huge market borrowing and struggle through disinvestment. The issues around cost optimisation, revenue maximisation, borrowing for consumption, insignificant public investment for creation of productive assets etc still remain valid with no sight on early resolution. The combined issues around twin-deficits in the absence of long term sustainable solutions (and remedial actions) do not provide the desired comfort for RBI on long term inflationary expectation. All taken, there is no case for shift to dovish monetary policy stance as yet!
Interest and Exchange rate conflicts remain valid:
The pulse of a strong economy is felt from price-stability of its exchange rate and not from bullish equity market, when the momentum is triggered by chase of external excess liquidity! It is obvious that external liquidity driven rally in Indian equity and bond assets (triggered by FIIs and followed by domestic traders) is not sustainable over long term unless backed by robust macroeconomic fundamentals. While long term growth prospects of India emerge as support to Indian equity market, FIIs stay put on Indian bond markets is dependent on yields (and rates) remaining attractive adjusting to inflation differential with minimal price volatility on USD/INR exchange rate. At this stage, squeeze of India-US bond yield spread will only result in exit of off-shore investment in India bond market to trigger one-way excessive weakness on Rupee unwinding most of the recovery from 68.85 to 58.33. All taken, RBI can not risk run on Rupee which will squeeze Rupee liquidity (through its $ sales) setting up upward bias on short-term interest rates.
Can India stand alone when most Central Banks are in ultra-dovish monetary policy stance?
RBI can not afford to ignore developments around Indian financial markets! The external system is let lose with huge liquidity at low interest rates and weak exchange rate. Their agenda is to boost demand for higher utilisation of existing capacity through domestic consumption and to enhance exports through exchange rate advantage over peers (and competition). It becomes easy when the system is at low inflation, surplus current account and low fiscal deficit with no supply-side bottlenecks. India is different across all fronts, hence may not be prudent to follow their foot-steps, when impact cues are different! All taken, India may need to stay different (and alone) till structural dynamics turn supportive for shift to dovish monetary policy stance with long term comfort on growth-inflation dynamics.
RBI stuck between strong expectations and weak domestic cues:
RBI is not in an enviable position, stuck between the devil (rate cut pressure) and the deep sea (lack of optimism on the way forward)! If the major issue is on liquidity and exchange rate (to stay look-alike to other Central Banks), RBI can stay on the dollar bid for extended period of time (maintaining Rupee exchange rate competitive for Indian exports) with the twin agenda to build $ reserves and infuse rupees in the system. If excess Rupee liquidity is not sterilised through OMO bond sales, overnight operating policy rate will move down from Repo to Reverse Repo rate. Can the system afford 1% drop from 8.0 to 7.0% allowing crash in bond yields? It is obviously No, if it is going to trigger FII exit from Bonds forcing run on the Rupee. So, need to plan out of the box to retain operating policy rate at 8% when Rupee exchange rate value adjustment is being administered through $ purchases. The option has to be in combination of shifting refinance to MSF rate and squeeze of excess SLR held by Banks. When RBI came to the rescue of Banks through special dispensation measures to save mark-to-market impact from rising bond yields, it is pay-back time for Banks.
It is tough call to read Rajan's verdict!
It is toss-up between 25 bps rate cut and pause. What is important is the policy tone and guidance on the way forward. Even if RBI is pushed to deliver rate cut, the anguish will be felt in the tone. Whatever may be the verdict, price stability is guaranteed in the Money/Bond market. There may not be major impact on the Rupee exchange rate as RBI has band-width to provide protection either-way. The worst hit will be the equity market, but would be seen as correction to the stretched valuation. So, as always most stakeholders will find reasons (and logic) to speak supportive of Governor Rajan on whatever stance he may wish to take on 2nd December, and those who don't are few, hence irrelevant!
I will be surprised if Governor Rajan succumb to pressure and deliver rate cut! Whatever is the outcome, see post-policy price-stability in 10Y bond at 8.0/8.05-8.20/8.25%, NIFTY at 8150/8200-8550/8600 and USD/INR at 61.20/61.45-62.20/62.45.
Moses Harding
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