Finger on pause button, eye on inflation

Written by fe Bureau | Mumbai | Updated: Apr 2 2014, 11:13am hrs
The Reserve Bank of India (RBI) left the key policy rate unchanged at 8% on Tuesday, not convinced inflation had been tamed and preferring to giving the disinflationary process a little more time even though it conceded industrial growth was slowing with downside risks to the estimate of 5.5% for FY15.

With the central bank signalling it wants interest rates in the system to remain elevated, there appears little scope for banks to immediately cut their base rates, more so since their borrowing costs could rise slightly. The RBI will now provide more liquidity 0.75% of net demand and time liabilities through the 7- and 14-day term repo windows while reducing the amount available at the overnight window to 0.25% of NDTL.

However, in the absence of lending opportunities and sluggish loan growth, banks are unlikely to raise rates. The cost of funds could go up slightly but there may be no change in lending rates, Arundhati Bhattacharya, chairman, State Bank of India (SBI), said at a press conference.

Its business as usual for some time, Punjab National Bank CMD KR Kamath said.

Economists believe it could be a while before policy rates ease. If growth is no more than 5% for a couple of more quarters, which, by the central banks latest estimates, would constitute about 100 bps below the potential rate of growth, and CPI inflation heads below 7%, there will be room for the central bank to cut rates in the fourth quarter, Taimur Baig and Kaushik Das at Deutsche Bank wrote in a note.

They added, however, that given the signals being sent out by the RBI lately, inflation and growth would have to decline substantially and persistently for any easing to be entertained.

Explaining the rationale for a status quo, widely anticipated by the markets, governor Raghuram Rajan pointed out that although headline CPI may have come off, risks to the central forecast of 8% CPI by January 2015 persisted, primarily arising from a sub-normal monsoon following an adverse impact of El Nino. We believe rates are at an appropriate level, Rajan asserted at a media conference. The RBI projects inflation at 8% by January 2015 and at 6% by January 2016.

While headline CPI has fallen by 1.4% between November and February, the result of lower vegetable prices, the central bank believes these are unlikely to soften further. Moreover, it feels core CPI inflation has been flat at 8%, suggesting the continued presence of demand pressures.

The governor sounded extremely pessimistic about growth, pointing out there had been a retrenchment in both consumption and investment demand and adding the boost provided by agricultural production could wane; it expects the economy to grow at 5- 6% this fiscal from a little below 5% last year, albeit with downside risks to the central estimate of 5.5%.

Analysts point out that the move to provide more liquidity through the term repo windows is an attempt by the central bank to deepen the term repo market so that it reflects the true liquidity situation. These adjustments are unlikely to change the overall liquidity situation substantially, but the cost of liquidity will now be more determined by market action than by a rate fixed by the RBI, the repo rate, Standard Chartered wrote in a note.

In order to attract more foreign funds into gilts of longer maturities, the RBI rationalised limits on foreign portfolio investor (FPI) flows who can now invest only in government securities with a residual maturity of one year and above; in other words, they cant buy treasury bills (T-bills). The overall limit for FPI investment in gilts, however, stays unaltered at $30 billion; so the quotas freed up at the shorter end will be available at longer maturities. Given foreign investors have preferred to invest at the shorter end, there could be some slowdown in inflows into the bond markets; so far in 2014, FPIs, excluding sovereign funds/central banks, have opted for T-bills over gilts in order to avoid a duration risk. While approximately $3.5 billion has come in from such investors, close to $2 billion has moved into T-bills. The RBI said investors in the bond markets will be allowed to hedge interest income due in the next 12 months.