Credit policy: What lies ahead?

RBI was quite dexterous while being accommodative and hence does not have the same challenges as the Fed, which also had the backlog of the QE rollback

The external environment doesn’t sound too encouraging with the “R” (recession) word—even the “S” (stagflation)one—being reiterated in discussions.
The external environment doesn’t sound too encouraging with the “R” (recession) word—even the “S” (stagflation)one—being reiterated in discussions.

This particular round of policy-setting by Reserve Bank of India (RBI) was always going to be critical for the economy for many reasons. The high-frequency indicators available so far point to the economy doing rather well on, which is reassuring. At the same time, the markets have been quite volatile, though they turned positive on the eve of this announcement. Stocks are up, the currency is stronger, and bond yields are lower. This sounds too good to be true, juxtaposed with the inflationary concerns of households confronted with high prices. The external environment doesn’t sound too encouraging with the “R” (recession) word—even the “S” (stagflation)one—being reiterated in discussions.

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RBI has been quite steadfast in its battle against inflation, and hence has gone in for a significant 50 bps rate hike. This is based on two premises. The first is that inflation is a worry even if it is under control at around 7%. There has been no change in the forecast here for the year, which remains at 6.7%. But the fact that it is still out of range of the MPC’s tolerance zone and will be so for the next two quarters is reason enough to get aggressive here. The other premise is that growth is on target. The forecast here has not changed, and it stands at 7.2% for the year. The fact that India remains the fastest-growing economy is significant for RBI because it makes decision-making easier. Interest rates have a dichotomous impact on the economy. While higher rates can bring down excess demand forces and hence inflation, they can also come in the way of growth if the cost of borrowing goes up. This is a constant struggle for central bankers. But once there is a conviction that growth is on the right path, it becomes easier to tackle inflation in a more aggressive manner, which is what the policy has done.

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How much further will RBI go? Here, there can be varied opinions. If inflation remains high for all three remaining quarters, there will evidently be pressure to keep increasing rates. Another 50bps hike looks imminent and logical and will take the rate to 5.9% by the end of the cycle. This will still not yield positive real interest rates with inflation at 6.7%, but the negativity will be curbed. The OIS 1-year rate, which is what the market players hold sacrosanct, points to 6.25% or its whereabouts, and hence this theory says that the repo rate should get aligned at this level. Another theory espoused is that (while it is not designed this way) there is a relation with the Fed rate, and if the Fed decides to push up its rate to say 3.25% or so this year, given the historical difference of 350-400 bps with the repo rate, the latter should definitely cross 6%. Therefore, there are many guesses going around.

What will higher rates mean for the economy? Deposit-holders can heave a sigh of relief at the announcement, though the earlier rate hikes have not quite moved the needle at the ground level for them. The response of the banking system needs to be noted here as decisions will be taken depending on their flow of funds relative to the demand for credit. But some upward movement will definitely be there.

For borrowers, it will be a mixed bag. For those with rates fixed to the repo , there is no escaping the higher cost. Home loans and loans to SMEs tend to be linked to this benchmark, which will cause more pain to the borrowers. The days of easy money will be over as capital gets priced properly—the pandemic had led to rates coming down sharply as RBI took a stance of doing everything to save the economy. The cycle had to change anyway, and it was only a matter of time before it got reversed.

However, for the larger borrowers, where lending rates are based on MCLR, the increase in cost will be marginal as this benchmark is formula-driven, and when the deposit rates do not move up commensurately, intuitively, it can be seen that the base will also rise very gradually. Therefore, these companies will be better off than those who borrow on the basis of the external benchmark.

For other market borrowings, the situation will be very different. Government bonds have shown a different tendency since the last policy, where the increase in the repo rate had finally got the yields down by 25-30 bps on the eve of the policy. Clearly, these yields are driven by other factors such as liquidity in the system, policy actions of other central banks, fund flows, and so on. Therefore, the increase in cost would be less than 50bps and more likely in the range of 20bps on an average basis. This is good news for the bond market where rates tend to be benchmarked with G-Sec yields and, hence, the AAA and AA rated companies, which are the large borrowers in this market, would face a more gentle interest cost curve due to this increase in repo rate.

Central banks worldwide seem to be united in fighting inflation, quite like how they did everything for growth for two years when the pandemic started. Clearly, going too easy on liquidity infusion had provided a push to inflation that seems hard to control, guided as it by other factors such as the Ukraine invasion. RBI was quite dexterous while being accommodative and hence does not have the same challenges as the Fed, which also had the backlog of the QE rollback, a legacy of Lehman. The gradual but firm rollback by RBI hence stands out in this story.

The author is Chief Economist, Bank of Baroda Views are personal

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