High rates are proving a disincentive for investment. Besides, there is no reason to fear growth pushing up inflation
A lower cost of capital, as finance minister Arun Jaitley has held, will indeed give a good fillip to the Indian economy. Although we fancy ourselves as relentless hawks, we have never understood the argument that a rate cut will not help growth, especially at this stage of the cycle. First, the incentive to invest will surely depend on the rising demand that will come with lower rates. A lot is made about how the 2003-2007 up-cycle was driven by rising investment, but it should not be forgotten that this itself resulted from former RBI Governor Bimal Jalan’s sustained easing. Second, we believe we are a long, long way away from a situation of growth pressuring up inflation. FY15 growth, at our expected 5.5%, is way below our estimated 7.5% potential. Finally, real rates faced by industry are at historical highs, hurting economic recovery. On balance, we continue to expect Governor Raghuram Rajan to turn more dovish in December and cut rates by 25 bps in February.
We reiterate that lending rate cuts hold the key to recovery. We have decomposed India’s growth slowdown of 300 bps odd into four factors: (a) global downturn (150 bps); (b) monetary tightening (75 bps); capex slowdown (50 bps) and erratic rains (25 bps). We see only a modest upturn in global growth, to 3.6% in 2015 from 3.1% in 2014. Capex is also unlikely to turn around in 1H2015. Against this backdrop, our 6.5% FY16 growth forecast critically hinges on 50-75 bps of lending rate cuts. Given that we have already entered the October-March busy season, it is unlikely that banks will be able to cut rates before April. As rate cuts typically take about 6 months to have effect, it will support growth only in 2H2015.
It is also critical to understand that investment has slowed down, not only in India, but all over the world. While the earlier “policy paralysis” in New Delhi may have stalled infrastructure projects, the fact is that the global downturn has dampened the incentive to expand capacity. Against this backdrop, the capex cycle is unlikely to recover in 1H2015 unless rates come off to support domestic demand.
We are a long, long way away from the situation of growth pushing up inflation. In fact, RBI’s freshly-minted inflation model shows that a 100 bps increase in growth will fuel only 20 bps of CPI inflation given the slack in the economy.
Coming back to argument being put forth that a rate cut will not support growth at this stage of the cycle, isn’t it Econ 101 that a cut in interest rates will spur aggregate demand and investment? It is true that aggregate demand could spill over into inflation if the economy is growing beyond potential. However, the present challenge is surely to bring the economy back to potential than worry about what will happen after that. Although much is made of India’s “inflation problem”, the fact is that the inflation-growth trade-off is actually far superior to many other BRIC/TIM countries. India’s inflation is 1.3x of growth, far better than Brazil’s 32x and Russia’s 28x. The relationship between domestic growth and inflation has broken down in the face of ‘imported’ commodity price inflation coming-off with the tightening of global liquidity. With the US Fed’s tapering turning into rate hike expectations, commodity prices are expected to remain stable for now.
High rates are proving a disincentive to produce and invest. While the consumer faces CPI inflation, the producer’s pricing power is better measured by non-food manufacturing WPI inflation. On ex-post basis, real lending rates, at 12.5%, are at historical highs relative to the average of 8.8% since 1997. This is clearly hurting economic recovery. An RBI study recently estimated that a 100 bps increase in nominal lending rates reduces the investment rate by 11 bps in the short run and 61 bps in the long run.
We are growing increasingly confident about our call for a RBI repo rate cut in February. While the December policy should turn more dovish, Rajan may want to await further clarity on the inflation peak-off before actually cutting rates. In our view, of course, RBI is well set to achieve its inflation targets (assuming normal rains and Brent at US$100/barrel) of 8% for January 2015 and 6% for January 2016.
Doesn’t RBI need to hold high rates to support the rupee at a time of a stronger dollar? Not really, in our view, with Rajan recouping FX reserves. Experience suggests that high import cover—rather than high rates—hold the key to rupee stability. Our call that RBI should be able to hold the rupee at 58-62 to the dollar, with falling oil prices and gold import curbs offsetting the dollar, is holding good so far. In fact, the rupee appreciates (depreciates) when RBI cuts (hikes) rates. That is because the FII equity portfolio, at about $330 billion, that responds to growth, is 6x the FII debt portfolio, that may respond to higher rates. In fact, July 2013 shows that expectations of MTM gains on perceived rate peak-off have been a bigger driver for FII debt inflows. The rate differential, at 800 bps, is already far higher than the average 460 bps since January 2003.
Edited excerpts from the Nov 18 India Economic Watch report of the Bank of America Merrill Lynch
By Indranil Sen Gupta & Abhishek Gupta
The authors are India Economists at DSP Merrill Lynch (India)