The world?s largest democracy, India, and the world’s oldest democracy, the US, have a few notable economic achievements in recent times. Both the countries, led by able central bankers, have managed to ?squeeze inflation without crushing growth?.
Even finance minister P Chidambaram, who had disagreements on certain Reserve Bank of India’s inflation policies, has now openly showered praises on RBI?s achievement in curtailing inflation.
To sum up, for the first time in two years, RBI governor YV Reddy will be a bit more comfortable while announcing the review of the annual monetary policy this month-end. Now analysts and bankers say inflation rate will continue to remain below 5%, which was not the case in January this year when the rate was around 6%-plus levels. This dip in rate was on the back of the base effect of RBI’s monetary measures and fiscal measures of the government in FY07.
?Going forward, we expect inflation to remain at sub-5% levels for rest of this year and this is in line with the RBI?s target of 5% in FY08,” said a Citi Group?s India outlook report.
?We reiterate our positive stance on the economy with GDP growth likely at 9.3%; inflation at sub 5%, the fiscal deficit under check, the rupee to continue its appreciating trend and the 10-year bond likely to trade in a narrow range given that falling inflation will likely be offset by higher oil prices,?? it said.
Bankers and economists agree that the backdrop of the RBI’s monetary policy, due on Tuesday, is a bit different compared to the past. Growth momentum continues to be strong (GDP at 9%+ and a double-digit industrial production). This is accompanied with both inflation (4.27%) and credit growth (24%) being much below the targeted levels of RBI (inflation at 5%; credit growth at 24.5%) for FY08.
Only money supply growth remains above the targeted level of 17.5% and this is largely due to capital inflows and the mopping up of dollars by the RBI.
?Though this makes a case for lower rates, we expect RBI to keep rates on hold. While it?s difficult to predict the timing, we expect the RBI to continue to use the CRR as a liquidity-absorption tool,?? explained Citi?s note.
With investment growth twice that of consumption, the capacity constraints are being addressed. This, coupled with benign inflation trends and a deceleration in credit growth, warrants a case for easing rates. The case gets stronger as higher rates have resulted in more reliance on foreign currency debt and higher inflows. However, given its stance to err on the side of caution, coupled with RBI’s medium-term inflation target of 4%-4.5%, bankers expect the RBI to wait for more data on inflation and credit growth, and thus see an extended pause in the repo/reverse repo rate hikes.
But the cash reserve ratio (CRR) is likely to be used to mop up dollar inflows.
With pressure from the exporters lobby to keep the rupee above Rs 40-a-dollar levels, managing dollar inflows has been one of the RBI’s main dilemmas. Forex reserves have risen by $20 billion so far this fiscal, with total reserves currently at $219 billion.
Incomplete sterilisation, coupled with government spending and the Rs 37,000 crore unwinding of FY07’s balances have made liquidity management a key concern for policy-makers. Call money rates have plummeted to historic lows (0.2%) for the last two months. This in turn has resulted to a cut in deposit and lending rates ? exactly contrary to what the RBI was trying to do a few months back.
Liquidity management options ? CRR hike and MSS issuances:
Earlier this year, the RBI raised the threshold limit for the market stabilisation scheme (MSS) to Rs1.1 trillion and modified it to include a mix of both treasury bills as well as dated securities. With outstanding MSS currently at Rs 800 billion, bankers feel that the RBI can absorb another $7.5bn via MSS issuances. The disadvantage of MSS is that the interest cost would add to the fiscal deficit. Thus, while timing is difficult to predict, bankers expect the RBI to use the CRR as a liquidity absorption tool. A 100 bps hike in the CRR would suck out liquidity to the tune of $7.5 billion. With the large capital inflows through the foreign institutional route, the RBI?s intervention to stem the volatility of appreciating rupee coupled with some uncertainty have led banks to park funds in treasury than lending.
Besides, with overnight rates being sub one per cent levels, treasury deposits, including bulk deposit rates have softened too but lending rates continue to remain marginally ?easy to steady’.Lending rates are least likely to be affected despite the liquidity scenario as most banks, including the apex bank, are still clueless about how long the situation could remain this way.
Ten-year bonds, which were above 8% levels for long, are now at 7.8% These are indications that rates are expected to slide in the next three to six months, if the current trend continues and the benchmark bond rates could hover in a 7.6 to 8.1% range.The rupee too is seen appreciating beyond 39 levels a dollar, if the current trend is any indication.
Bankers seem to have accepted the fact that rupee appreciation is an issue they have to deal with on a day-to-day basis. But some feel that the government should also find ways for an exit route of such capital inflows? either by relaxation of outflows for high net worth individuals or aggressively increase its sterilisation measures? instead of a half-hearted approach. Till the time no such moves occur, bankers have maintained a conservative view on interest rates in the near term of three to six months. In the longer term, however, interest rates are seen easing, despite the rupee seen below 40 a dollar.
Said Bhaskar Ghose, managing director & CEO of IndusInd Bank, ?I don?t think interest rates would be touched upon during the quarterly monetary policy review by the Reserve Bank of India on July 31. Any further rise in the interest rates is out of the question. Even no cut is likely in the interest rate.?
On further liberalisation in the outflow of forex by RBI, Ghose said: ?There is lot of forex flow into the country especially through the FII route. In fact, it is partly the reason why Indian rupee has got stronger against the US dollar in the recent past. As there is an apprehension that exports may start falling due to the strengthening of rupee, the RBI may take some steps in its bid to ease this pressure.?
While saying RBI has to walk a tightrope, TS Narayanasami, chairman & managing director, Bank of India, pointed out: ?Rates have softened. If the interest rate scenario continues the same, the system will have to relook prime lending rates. The benefits of declining cost have to be passed on to the consumer. I don?t think RBI will take any action which will lead to hardening of rates.?? According to Keki Mistry, managing director, Housing Development Finance Corporation, if RBI refrains from hiking any key rates, lending rates will either stabilise or fall. The interest rates are expected to remain flat, said Naina Lal Kidwai, CEO, HSBC India. Can governor Reddy read the situation differently?
