No economic case for another rate cut soon

July 30, 2015

(Any opinions expressed here are those of the author and not of Thomson Reuters)

There is no doubt that India’s growth has not picked up in line with expectations. In fact, most activity indicators — whether it’s manufacturing growth, corporate earnings, power generation, passenger vehicle sales, exports growth or non-food credit offtake of commercial banks — have shown increasing weakness in recent months.

On the other hand, headline CPI inflation — the nominal anchor for monetary policy — accelerated to a nine-month high of 5.4 percent in June on the back of higher prices of select food articles and increased core inflation reflecting a hike in service tax and higher fuel costs.

While the statistical base effect should keep CPI inflation under control for the next two months, insufficient monsoon rains in parts of Maharashtra, Andhra Pradesh, Telangana and Karnataka until end-July may create price pressures for pulses, coarse cereals and cotton. The Indian Council of Agricultural Research has said rainfall shortage in some regions of these four states is as high as 50 percent.

Yet, the current economic conditions show a combination of a shallow economic recovery, subdued credit dynamics and fairly controlled retail inflationary pressures thanks to much weakened aggregate demand (both investment and consumption) and a crash in commodity prices, especially oil prices.

Moreover, given the differential weights of food articles in CPI and WPI and the differential distribution of pricing power between manufacturing and service sector companies, the WPI and CPI are showing divergent trends. In June, WPI showed negative growth for the eighth consecutive month. For many, this scenario certainly warrants another rate cut to stimulate investment activity.

But the key issue before the Reserve Bank of India is whether another rate cut would really help. So far in the current calendar year, RBI has reduced repo rate cumulatively by 75 bps but commercial banks have reduced their key lending rates by just 25 to 30 bps.

The impact of central bank action on the term structure of interest rates is the basis for wider transmission of monetary policy stance to real activity and eventually to price developments. Banks, especially public sector banks (PSBs) are not able to reduce lending rates, as their asset quality is continuously declining (further vindicated by Q1 FY16 results) and hence, credit costs are rising.

Given the tardy process of structural reforms and fragile recovery, their non-performing assets (NPAs) are likely to deteriorate to lower buckets (sub-standard to doubtful to loss), and will lead to potentially higher credit costs. As net interest income (NII) is the major source of income for PSBs and as they are reeling under the pressures of stressed assets and inadequate capital buffers, it is practically impossible for them to reduce the lending rates, even if the RBI comes out with another rate cut.

The response of private sector banks need not be much different, as consistently decelerating corporate sales growth and reduced cash flows signal pressures on their asset quality as well. In fact, private banks’ response to monetary policy signals in the year 2015 has been more muted compared to PSBs, as they are more profit-oriented.

While all central banks like to maintain that they have a purely domestic mandate, they cannot afford to ignore international developments. Both Janet Yellen (U.S. Federal Reserve Chair) and Mark Carney (Governor of the Bank of England) have hinted recently that they have come close to break with the ultra-low interest rate regime since the breakout of the global financial crisis in 2008.

This has prompted central banks of some emerging markets to shift the stance of monetary policy in favour of tightening this month. For example, central banks of Kenya, Uganda and South Africa have tightened policies recently. Many other emerging market central banks (especially those with weak current accounts) may follow suit in the remaining part of the year to prevent capital outflows.

Given the fragility of India’s economic recovery, we do not expect an abrupt rise in rates soon, but the probability of rate reduction also looks slim. A bigger concern has to do with the rise of the dollar, which has increased markedly against the Indian currency over the past year, partly also reflecting its weak external fundamentals driven by a sustained contraction of exports (in volume terms) and deteriorating net international investment position.

Last but not least is the need to reassert the RBI’s commitment to the inflation-targeting framework against the backdrop of the recently released draft version of the Indian Financial Code that recommends higher participation of the government in the selection of monetary policy committee members and in fixing the CPI target.

As a result, many analysts have started expecting a dovish bias in monetary policy going forward. Even if it is a draft version and the government has invited public comments on its recommendations, the RBI would like to stay the course to avoid any buildup of irrational expectations.

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