By Nikhil Gupta
With a consensus of 5:1, the Reserve Bank of India (RBI) hiked policy interest rates by another 50 basis points (bps), taking the repo rate to 5.9%—higher than its mid-2019 level. Monetary Policy Committee member Ashima Goyal was the only dissident, having voted for a 35 bps rate hike. While the central bank’s inflation projection for FY23 was left unchanged at 6.7%, its downgrade of the real GDP growth target to 7% (from 7.2% earlier) was lower than expected (RBI revised its H2FY23 projections upward to 4.6% from around 4% earlier).
Although Governor Shaktikanta Das mentioned the hazards of offering any forward guidance in the present context, he stated that the central bank’s actions will be based on “the incoming data and evolving scenario, without being constrained by conventional or any textbook approach to policy making.”
As a market analyst, irrespective of the level of uncertainty, our job requires us to make medium- to long-term forecast, with the privilege to make revisions based on incoming data and new developments.
One or more rate hikes?
This is at the centre of the exercise to determine the terminal rate. Motilal Oswal had expected the terminal rate at 6% for many months now. With the repo rate at 5.9% now, that forecast has to be revised.
The terminal rate will depend on whether the hike in the next monetary policy meeting in December will be the last in this cycle or there will be more. The answer to this question will determine if the terminal rate will be 6.25% or higher.
The (revised) base case now is of a 35 bps hike in December, followed by another 25 bps hike in February next year. It is, thus, very likely that the terminal rate during this cycle can be as high as 6.5% by FY23-end.
RBI has kept its 2QFY23 inflation projections unchanged at 7.1%, which implies that it expects headline inflation to clock around 7.5% in September, up from 7% in August. If this plays out, it will raise calls for another 50 bps rate hike in December (especially if the US Federal Reserve repeats its 75 bps rate hike in November).
If so, an obvious question will be the impact on the benchmark 10-year bond yield. There are two notable trends working against each other. First, after the hike, the spread between the repo rate and the 10-year yield is down to around 1.5 percentage points (pp), almost half of the more-than-3pp in April and May (on a monthly basis). Do note that the spread is still higher than the average spread of 1.2pp in 2019, which was less than 1pp in the 2010s decade (2010-19).
At the same time, with the sharp surge in the US treasury yield, from under 3% a few weeks ago to around 4% now, the gap between India’s and the US’s 10-year yield has narrowed to 3.6-3.7pp—marking the lowest level in 13 years—against 4.5pp till mid-August.
These two trends lead to different conclusions. While the former advocates that India’s bond yield may stay between 7.5% and 7.7%, even if the repo rate is increased by another 50-60 bps, the latter suggests an upward adjustment in domestic bond yields to maintain the historical spread vis-à-vis the US yields.
We are more tilted towards the former over the next few months, and thus, believe that the 10-year yield can stay under 7.8% over the next few months.
RBI’s forex intervention lower than what was perceived
It is important to note that, contrary to the widely held perception, RBI did not intervene excessively in the currency or forex market in the first half of FY23. Based on the recently released Balance of Payments (BoP) data, it is clear that foreign capital flows in Q1FY23 were more than the current account deficit.
India’s foreign exchange reserves (FXR) rose by $4.6 billion in Q1FY23, based on the BoP. However, FXR declined by $18.1 billion in Q1FY23 due to the valuation effect—as explained by the appreciation of the dollar against major currencies and higher US bond yields.
Assuming India’s FXR at $530 billion by September-end (it was $537.5 billion on September 23), calculations suggest that only about half of the depletion in FXR in Q2FY23 was due to RBI’s intervention.
As Governor Das pointed out, valuation changes are behind the almost-67% decline in FXR in H1FY23 (equalling about $77 billion), implying that only about $26 billion is attributable to RBI’s intervention (or BoP). In any case, it suggests that RBI has been judicious (to borrow from the RBI Governor) in using forex reserves to defend the currency.
It also tells us that India’s forex reserves will continue to fall over the next few months, even if the RBI does not intervene in the currency market. The rupee will continue to be driven by global factors and emotions, which certainly indicates a further appreciation in the dollar. If so, the rupee may weaken further vis-à-vis the dollar in the coming months.
Expect more downgrades in real GDP growth
Notwithstanding the weaker-than-expected real GDP growth in Q1FY23, RBI has increased its projections for H2FY23 (to 4.6% from around 4% earlier) and for FY24 (to 6.5% from 6.3% in April, as per the Monetary Policy Report).
While the Fed, the Bank of England, and the European Central Bank have revised their 2023 growth forecasts dramatically downward in the past six months, an upward revision by RBI is very surprising to say the least.
It reflects RBI’s confidence in India’s divergent growth and can also fuel further rate hikes. As we do not see India remaining isolated from a global slowdown, we expect further growth downgrades in the economy, especially for FY24.
The author is Chief economist, Motilal Oswal Financial Services