High interest rates drive forex flows, make ` stronger, force RBI to intervene which pushes up GSec rates further
Apart from the fact that consumer inflation has risen 30 bps since RBI’s monetary policy committee (MPC) last met and is likely to rise further, the argument made for why RBI will not cut rates is that, with GSec rates at over 7%, there rate cycle has turned; SBI raising bulk deposit rates by 100 bps is proof of that. The arguments are valid to the extent the case for a rate cut today is not as strong as some months ago—but more than anything else, it just shows how tight a corner RBI has got itself into by not cutting rates when CPI was so low for so many months. How much GDP India has lost due to incorrect RBI policy is another matter, and certainly will be many times higher than the loss former prime minister Manmohan Singh said was caused by demonetisation. The problem with the argument citing high GSec rates as a reason for inaction is that, if this is true, why even have an MPC or an RBI. The fact is, monetary policy matters, and RBI has to use this tool to help the economy, though obviously it is not the only measure required. Indeed, GSec rates are high because the markets are anticipating a hawkish policy, looking at the fisc slipping and the rupee further strengthening. In which case, a dovish policy may actually help lower GSec rates as the market will then unwind the positions it has taken. Such a policy will also signal the economy remains weak— some of the GST collections are probably an indication of that—and correct the bond market’s perception of the economy recovering fast.
While it is true CPI has hardened, with most CPI projections for FY19 in the 4-4.5% range, it is not clear why RBI needs to be worried enough to be changing its policy stance at this point. Indeed, if the central bank doesn’t help lower rates, forex flows will continue to pour in, making the rupee stronger, forcing the RBI to buy more dollars—if it doesn’t, local industry will get hit badly—which will further push up rates. In other words, a hawkish policy will not just keep GDP momentum down at a time when it needs policy support, it will push the already weak economy further into a hole. RBI is obviously in a quandary and has less room to manoeuvre than previously. It needs to buy dollars to keep the rupee in check, but this raises GSec rates as it needs to mop up the rupees it releases to buy the dollars. At the same time, it needs to keep a check on auctions to keep GSec rates down—that’s why it cancelled the last set of open market operations. In such a situation, though, a repo cut and a dovish outlook offer an obvious way out. The government also needs to do its bit by not borrowing more—to ensure this, selling more PSU stock to make up for tax and other shortfalls is a good idea. Equally, it has to find ways to stimulate the economy, since just monetary policy or government spending can’t do the trick—the banking recap, though, will help lower bank spreads a bit. Lowering telecom levies and raising gas prices plus allowing marketing freedom will boost investments in these two areas, as will a good exports policy for agriculture—that means no restrictions on exports or stock limits on industry—and clearing policies to allow FDI in food retail; other policies include reducing choking labour restrictions across the economy.