By Vivek Iyer
One of the interesting quotes I came across while reading Ray Dalio is that while History does not repeat itself it often tends to rhyme. A high inflationary global environment that spiralled out of control has been experienced by the world, during the times of stress such as the earlier world wars of the 1915s and the 1940s and the energy crisis of the 1970s. However, given that both these poetries were many decades ago, the world has gotten used to a low-interest rate environment with an extremely accommodative stance from the central banking regulators globally. Let us understand three variables that are impacting the interest rate setting today, so as to better understand the direction of the RBI Monetary Policy Committees (MPC) thinking and thereby the decisions.
1) Geo-political risks – The geo-political risks on account of Ukraine – Russian conflict has essentially pulled the entire Europe into the war. This will result in a significant slowdown in the overall European economy. Further, the declining nature of the Sino-American relationship will result in significant re-alignment of supply chain relationships globally. While this will not happen overnight, the period of change will be beset with high inflation on account of supply-side issues.
2) Inflation and Financial Stability – CPI in July 2022 was 6.71% and is widely expected by different economists to be close to 7% in August 2022 and September 2022. RBI’s own projections also expect the interest rate to stay above 6% for the entire period of FY 23. Inflation expectations have a tendency to magnify financial stability risks. Higher inflation expectations reflect an environment of uncertainty and business investments tend to be slower on account of the same. Hence, managing inflation expectations in the short term to medium term is extremely key to maintaining financial stability in the long run.
3) Global Interest Rate Hikes – Federal Reserve is expected to raise interests by 75 basis points. European Central Bank (ECB) has already raised interest rates and the Bank of Japan (BOJ) is expected to consciously uncouple from its super easy policy for decades. In an environment where the US, Europe and Japan increase interest rates, the value of the rupee depreciates given the desire to park assets in safer assets at a higher interest rate. Hence, it becomes imperative to raise interest rates, to keep the rupee exchange rate within a certain permissible range (currently seems to be around USD/INR 79 to USD INR 80). While market interventions have also played a key role in keeping the rupee range bound, managing exchange rate stability through interest rates is more of a proactive measure as compared to market interventions by the Reserve Bank of India (“RBI”).
Given the above three variables, the MPC in my humble view will suggest a rate hike. While the quantum of the rate hike is being evaluated between 35 basis points to 50 basis points by many economists, the thought process on the need for a rate hike seems unanimous across the market spectrum. While globally there is a school of thought that rate hikes seem to be inducing a recession – in India, the rate hikes will only reduce the rate of growth and not kill it. That’s the mindset of the RBI as well as our belief, basis the communications from the regulators at different forums.
It will also be worthwhile for the regulator to continually look at initiatives to increase the flow of foreign capital in the country through:
- rationalization of FPI limits for G-Sec holdings,
- broadening the definition of priority sector to include more client resiliency initiatives apart from just renewable energy,
- innovations on cross-border payments, promotion of rupee as a mode of settlement with more countries apart from just Russia and
- rationalization of tax rates for foreign banks to promote more competition and attract more investment in the Banking sector.
- while we expect, the RBI may take a hawkish stance on interest rates, our request to the regulator would be to hold an accommodative stance on growth through its other policy initiatives.
(Vivek Iyer, Partner and Leader, Financial Services – Risk Advisory, Grant Thornton Bharat. Views expressed are the author’s own.)