The RBI monetary policy decision is the next trigger for Indian capital markets. While I expect a 25 bps cut in the current meeting, and another 25 bps cuts in the next meeting in October, the better option in my view would be to go in for a 50 bps cut in a single stroke.
The central bank has room to cut policy rate. The last Consumer Price Index (CPI) release reveals that the inflation continues to be benign, based on June CPI of 3.18 percent, the real policy rate is currently 2.57 percent. If core inflation of 4.1 percent is used instead of headline inflation, the real rate works out to 1.65 percent. This, we believe, is quite high and gives room to the RBI to lower rates. To understand the impact, one needs to keep in mind the current growth and inflation backdrop, the reasons for current weak growth and how it may change on account of the RBI policy.
Inflationary expectations remain well anchored. The RBI’s May 2019 household inflation expectation survey reveals that inflation expectations for three months ahead have declined by 20 bps, while expectations for one year ahead remain unchanged. Importantly, both have declined significantly since September 2018. Benign commodity price environment also helps anchor inflation expectations. Core inflation has been on a decline. I believe it is likely to converge with headline inflation in the months ahead. Inflation is likely to range between 3.5 to 4 percent. I also believe that some of the decline in inflation is structural and thus, unlikely to be a threat on account of lower rates.
The reasons to cut rates, however, arise more from the weak growth environment. Economic growth prospects have declined considerably since September 2018. Economic growth, especially private consumption, got a boost from the seventh pay commission implementation the first half of 2018. Ahead of the festive season in 2018, Indian manufacturers increased production, anticipating good demand.
The IL&FS default caused a liquidity crunch in the Indian economy, leading to a sudden slowdown in consumer on account of a credit squeeze. Political uncertainty ahead of the general election and slowdown in government spending also contributed to the slowdown. High real interest rates also have contributed in the slowdown. Interest-rate sensitive sectors were the hardest hit; these include consumer durables and autos where sales are made on credit.
Though banks’ credit growth has picked up, NBFCs lending has slowed down considerably, especially beyond the major urban centres of the country. The unexpected slowdown has also led to an inventory build-up, which has caused manufacturers to cut production to clear inventory. Since then the economy has decelerated further.
The RBI has acted to these events. It has carried out a number of open market operations, or OMOs, to infuse liquidity. It has also infused liquidity via FX swaps. As a result, the monetary system is now in surplus, the system has had a daily surplus of Rs 1.3 trillion since July beginning. The RBI has also cut the repo rate three times, i.e. a total reduction of 75 bps and now stands at 5.75 percent.
RBI actions should have an impact. So, are more cuts needed? I think that more action is needed. There are four issues. Firstly, the transmission of monetary policy appears broken, secondly, there are emerging threats to the Indian economy from developments in the global economy, and thirdly, while the budget had some good proposals, certain tax proposals haven’t been well received and have dampened business sentiment. Lastly, the government is fiscally constrained, which means the RBI has to do much of the heavy lifting.
The yield on a 1 year BBB rated paper was 8.6 percent in August 2017, this rose sharply in H2 2018, peaking at 12.3 percent in October 2018, and though it has declined, it still stands at a high rate of 10.5 percent.
The monetary system transmission has been poor and this is being tackled. The government is recapitalising banks, with Rs 7,000 crore budgeted in the fiscal. They have launched a limited onetime credit guarantee scheme for pooled assets issued by housing finance companies. While this may help, further rate cuts are needed by the RBI to aid rate transmission from the central bank to the real economy.
Global uncertainties have risen, with a fresh round of tariffs announced on Chinese goods by the US on August 1. The global economy has lost momentum and trade wars have increased risks. The Chinese Yuan has gone past the 7 (to USD) which reduces competitiveness of Indian exporters. However, with a rate cut by the US Federal Reserve, and hints of further easing by the European Central Bank, the room for emerging market central banks to ease policy has increased. The RBI thus needs to and has more room to cut rates, not only because of domestic reasons but also to prevent spill over of a weak global economy.
Recent tax proposals, specifically FPI surcharge, haven’t been well received and soured sentiment leading to outflows. Capital market developments can have an impact on the market and on the real economy. A rate cut can help revive business sentiment, which is important as it can impact investment decisions.
The government has fiscal constraints. The fiscal deficit target of 3.3 percent of GDP may be missed on account of potentially lower tax collections due to a weak economy. July’s GST collections rose by 6 percent YoY, a sign of a slowdown. Thus, the government is constrained in terms of the fiscal stimulus it can provide via spending on infrastructure. While the government has constraints, the RBI has space to provide stimulus. I would urge the RBI governor to front-load rate cuts and go in for a 50 bps cut.
I expect that the economy may stabilise in Q2 FY2019-20, and gradually improve. But, strong growth that the economy needs to generate strong jobs may continue to elude unless it gets some help from the central bank.
The author is CEO – Stock Broking at Karvy.
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