The prevailing macro backdrop has complicated policy choices for the Reserve Bank of India (RBI) as it formulates the quarterly monetary policy. Yet, we, at Standard Chartered Bank, expect the RBI to continue with its gradual approach of normalising interest rates at the quarterly monetary policy meeting on July 27. Market consensus is for a 25 basis points (bps) hike in both repo and the reverse repo rates, and we agree. Economic recovery appears to be well under way in India. However, managing the recovery is turning out to be as daunting for the RBI as battling the preceding crisis. In some ways, the policy choices might have become even more complex because the days of uninterrupted monetary stimulus are over and policy-makers are confronted with a number of textbook dilemmas.
We expect the following four macro issues to shape the RBI?s monetary policy stance in the coming months. One, strong capex-led growth, but there are early signs of moderation in the astronomically high industrial growth rates. Second, substantially higher levels of uncertainty over the global growth outlook in H2-2010. Three, persistent, pervasive and painful inflation, but the trajectory could be downward. Four, near-term tightness in systemic liquidity and the growing divergence between deposit and credit growth rates.
India?s industrial performance in recent months has been nothing short of spectacular. From an average industrial growth rate of 1% in the first five months of 2009, the figure surged to 12.5% over the next 12 months. GDP growth also edged above the psychological barrier of 8% in Q4FY10, and the IMF projects the GDP growth to be as high as 9.4% for 2010.
However, industrial growth rates are likely to moderate, going forward, as witnessed in the IIP print for May (11.5% year-on-year from a downwardly revised 16.5% year-on-year in April). With monsoons disappointing so far, there could be question marks on agricultural growth as well. Official releases already point to weak private consumption growth, and the growth momentum is primarily driven by a capex recovery. Any spike in borrowing costs is fraught with the risk of stunting investment growth. Hence, it would be difficult for RBI to be complacent about the domestic growth outlook at this juncture.
Even from an external-demand perspective, the outlook appears cloudy. With uncertain growth prospects in the developed world?the Fed has lowered its forecast for US growth; Europe is struggling with a sovereign debt crisis?and China showing signs of slowing down, exports are unlikely to provide much support to the growth momentum.
The current inflationary episode began with food prices, and the first line of defence was on the fiscal side via a plethora of measures announced in late 2009 and early 2010. The monetary policy was kept on hold because it is mostly ineffective in addressing supply-side issues.
There was a general expectation that food articles inflation would slow significantly once the winter crop arrived in the market and fiscal measures started to take effect. However, the drop in food articles inflation from its peak of 20% in December to 14.6% in June was far more gradual than expected. On the other hand, non-food, non-fuel core inflation has surged to close to 9% at present?from just 1.5% in December?clearly demonstrates that demand-side factors have started to influence inflation.
Capacity constraints are emerging in some industries, pricing power is returning, and recovering labour markets might have been pushing wages higher. More importantly, price pressure is spreading fast. While monetary policy action is required, the pace at which the RBI should move remains debatable. The direct and indirect effects of the recent fuel price hike are likely to keep headline inflation high in the near term; however, it should start moderating substantially from the last quarter of 2010.
Subdued commodity prices on the back of an uncertain global recovery would support this forecast, but we still need to keep an eye on the monsoon. Although RBI has been criticised for falling ?behind the curve? (real interest rates are negative), one must appreciate that part of the normalisation of real interest rates is likely to happen because of an expected fall in inflation. Thus, a substantial hike in interest rates might not be necessary to correct the anomaly of negative real interest rates, even when the current inflation rate seems to be calling for a stringent action. Hawkish rhetoric is required to rein in inflation expectations and inflation acceptance.
The tightness of systemic liquidity is another issue that RBI will have to consider when deciding on its monetary policy stance. It needs to ensure sufficient liquidity to support the huge government borrowing programme, but it will also be mindful that excess liquidity should not fuel goods or asset price inflation. The market expects liquidity conditions to ease from end-July; however, we think that the tightness will continue well into August and September. There could be intermittent respite from this liquidity pressure and it is likely to be less painful than in June and July, but the chances of achieving comfortable liquidity levels look bleak to us. With the operative policy rate now becoming the repo rate, the effective policy rate has risen by 150 bps over and above the 75 bps of hikes implemented by the RBI since March 2010. In the light of this, we believe, the central bank is likely to opt for a gradual hiking stance.
There could be two possible variants to this gradual stance of hiking both the repo and reverse repo rates by 25 bps each: narrowing the repo-reverse repo corridor by raising only the reverse repo rate by 25 bps, leaving the repo rate unchanged; or raising the repo rate by 25 bps along with a 50 bps hike in the reverse repo rate. While the former could be interpreted as extremely dovish, the latter might become too hawkish, and run counter to the RBI?s stance of favouring gradualism.
The author is regional head of research, Standard Chartered Bank