The June monetary policy decision is surely not about rates and stance alone. This policy represents a closely coordinated action by the RBI along with the government to squarely address possibly the most important risk facing the Indian economy — external imbalances, arising more from capital outflows than as a clear risk from the current account end. As regards the rates and the stance, there is a hint of hawkishness in the RBI’s messaging. But the clear view remains that the central bank is unlikely to react to the rising inflation forecasts with a rate hike, unless it has crystal clarity on whether the inflation is temporary or permanent and if there is a significant second-round impact of the inflation dynamics.
On the government’s part, it announced measures to deepen the government securities (G-sec) market by seeking to increase participation of foreign portfolio investors (FPIs) in the Fully Accessible Route (FAR) whereby FPIs now can invest in the 15-, 30-, and 40-year buckets. Under the general route, there was more flexibility given to FPIs by removing the restrictions that exist now on limits for short-term investment, concentration limits, and security-wide limits.
Further, the government has now done away with the long-term capital gains tax and the withholding tax on FPIs for investments in the G-sec market. The withholding stand was a sticking point against India getting included in the global indices. It is thus an important step from the longer-term perspective.
The RBI chipped in with its own contribution by offering concessional forex swap for external commercial borrowings (ECBs) raised by PSUs. Further, it offers to fully absorb the hedging cost if banks raise foreign currency non-resident (bank) FCNR (B) deposits for the three-five-year period. On paper, the benefits of these policy measures could potentially be large. Yet, at this moment it is difficult to quantify the extent of flows that may be anticipated.
First, we do not think that the FPIs will change their risk perception of India by being allowed in the longer tenor buckets, given the interest rate risks existing today and a likely tightening of monetary policy in India sooner or later. FPIs’ view on the India markets would thus be hugely dependent on a call on local interest rates. This accounts for the huge unutilised space under the FAR route.
ECB flows could pick up, but we believe the extent of fresh inflows may not be higher than $4-5 billion. On the FCNR(B) front, the deal has been sweetened by taking off the cash reserve ratio and statutory liquidity ratio requirements — if offered along with leveraging facilities, they could garner $35-40 billion. Overall, these measures are likely to lead to a one-time capital flow boost to correct/contain the balance-of-payments deficit for FY27. The advantage derived from these flows would also be that it would boost the RBI’s FX reserves, thereby pushing up the ammunition to fight rupee depreciation pressures in the future.
There remains a strong probability for rate hikes to start in August. Clearly, monetary policy has a limited scope to address supply-led price shocks and there may be merit in the RBI not reacting to price signals and projections on inflation immediately. The RBI sounds cautious on inflation trends and tweaks Q3FY27 inflation to 5.9%, close to the upper end of the corridor. But in the same breadth, it points out that core inflation is low, implying absence of any demand-side pressures on prices.
While we wait for the Monetary Policy Committee minutes to form a better view, like in April, the RBI took the unanimous decision to pause as it wanted to avoid any policy missteps of hiking earlier than necessary which could further worsen the growth outlook from the currently anticipated 6.6% for FY27.
The RBI has thus bought time to understand the second-round implications of the supply shocks on prices, the incremental pass-through of higher crude prices to the pump-head prices of petrol and diesel, the pass-through of higher input costs of manufacturers to the retail side, and the impact on food inflation due to the anticipated El Niño and weaker monsoon. Tracking household inflation expectations would be important for the RBI. As revealed by the latest RBI surveys of household inflation expectations, both the three-month and one-year inflation expectations have continued to move up.
The increase in inflation forecasts and rising inflation expectations lead us to believe that an eventual rate increase is on the cards. All policy meetings remain live from here on as the RBI factors in incremental data into its reaction function. We now see a high change (almost 60%) for a rate hike cycle to start in August, by which time the central bank would have seen two more data prints on inflation and would have broadly understood the implications of El Niño and the consequent deficit monsoon on food inflation. Given that the average inflation for FY27 is placed at 5.1%, and assuming a 100-basis-point (bps) real gap that the RBI would want to maintain, a 75-100-bps rate hiking cycle remains on the table.
The policies to boost capital flows have had their impact on the currency and interest rate markets post-policy. USD/INR is down to 94.94 at close, but this may be a knee-jerk reaction as we would have to wait for the authorised dealers to start targeting the FCNR(B) flows and the actual realisation of these flows may be a month away. Broadly, until the West Asia crisis sees a firm resolution and oil prices fall lower, the risk of INR depreciation remains. For the bond markets, the 10-year G-sec dropped by around 3 bps and may not see any further sharp dips, given a fear for the fiscal maths in India on account of the government’s subsidy bills on LPG and fertilisers, and a looming perception of rate hikes in India.
Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.