The Reserve Bank of India (RBI) Monetary Policy Committee’s (MPC) rate decisions will continue to be driven by US Fed hikes to protect the rupee. It will likely need to raise the rate by another 50 basis points by April, with the Fed set to hike 125 basis points by May. The inflation imperative is met with the real repo rate returning towards zero.
This begs three questions. Should an inflation targeting central bank support the rupee? There is surely no point in inviting ‘imported’ inflation. Second, will this not impact growth? One way to mitigate the impact is by offering subvention of 1% on priority sector loans to micro and small industries at a fiscal cost of just 0.05%. Finally, how will sluggish deposit growth, due to RBI’s large-scale FX operations, fund rising loan demand? This will likely need RBI to buy government bonds through open market operations (OMOs) or cut the cash reserve ratio (CRR).
The RBI MPC should hike 25 basis points each, in its February and April 2023 meetings, and cut 100 basis points in September 2023-March 2024 after the Fed hikes end, and growth/inflation slips. This assumes the Fed hikes 50 basis points on December 15, 2022, and 25 bps each on February 1, March 22, and May 3, 2022. Fed rate hikes cannot but push RBI into further tightening as the differential approaches 200 basis point levels a la 2006. CLSA reckons:
If the Fed raises rate to 4.5-4.75%, RBI will likely hike repo rate to 6.50%;
If the Fed raises rate to 5-5.25%, RBI will likely hike repo rate to 6.75%;
If the Fed raises to 5.5-5.75%, RBI will likely hike repo rate to 7%.
This begs the question, do RBI rate hikes support or hurt the rupee? CLSA believe it supports the rupee when RBI is hiking rates to maintain a reasonable differential between the Fed funds rate and the RBI repo rate, as in 1998 and 2006.
This prevents speculators from arbitraging between the call money market and the rupee. In case RBI raises rates to expand the differential beyond the reasonable level, the rupee typically sells off, like what happened in July 2013.
After all, foreign portfolio investors’ (FPIs’) investment in equity is over 15 times that in debt. Higher rates that hurt growth drive away equity FPIs and impact the rupee. This results in a sell off by debt FPIs as well.
Flexible inflation targeting allows RBI to focus on multiple objectives. RBI rate hikes maintaining a reasonable differential with the Fed funds rate supports the rupee.
What happens if the unprecedented mix of global risks, limiting portfolio flows, and high oil prices due to war persists? Issuing National Bank for Financing Infrastructure and Development (NaBFID) bonds to non-resident Indians can raise about $25 billion to augment FX reserves and fund infrastructure growth at the same time. While listing Indian bonds in a leading emerging market bond index can boost foreign institutional investor (FII) interest by $30bn, this will take time.
The inflation imperative of monetary policy is met, CLSA believes, although RBI has rightly emphasised that the war against inflation is not yet over. RBI’s repo rate, at 6.3%, has crossed the 5.8% average FY20-23 inflation. Inflation should peak off to 5.5% in FY24, within RBI’s 2-6% target, from an average of 6.9% in FY23. Most estimates of India’s growth maximising threshold inflation also work out to 5.5%.
RBI will likely begin to cut rates once inflation hits 5.5% next year. After all, a combined US and European recession may well pull India’s FY24 growth rate down to 5-5.5%. An US recession typically costs the Indian economy 100 basis points of growth.
CLSA’s growth concerns also emanate from the fact that rising lending rates are just about beginning to bite and are definitely headed higher. In CLSA’s proprietary pre-Diwali survey, 66% of urban and 60.5% of rural respondents reported that lending rates were the key determinant in taking loans.
Among them, urban respondents said that mortgage rates were already beginning to hurt. And 73% of urban and 73.4% of rural respondents said rising interest rates were delaying purchases of vehicles.
It is for this reason that the Union government can be expected to offer 1% subvention on lending rates on loans to vulnerable sectors (40% of balance sheet) that are linked to the RBI repo rate.
RBI will need to inject ‘durable’ liquidity rather than temporising with repo operations as it did yesterday, to raise deposit growth to fund higher credit growth.
It has expectedly extended the statutory liquidity ratio (SLR) hike (to 23% of book) by a year to March 2024, to fund the high fiscal deficit. Looking ahead, RBI can be expected to infuse liquidity by either:
Conducting OMOs to fund the fiscal deficit if the 10 year pierces 7.5%, or,
Rolling back recent CRR hikes (by 1% of book) to boost deposit growth to fund credit offtake, as the ‘busy’ season intensifies, to prevent a spike in lending rates.
Can’t banks mobilise deposits by raising deposit rates? Not really.
The only transactions outside the banking channel in India are cash draws and post office savings. To illustrate this, if X buys a share from Y, funds flow from X’s bank account to Y’s, leaving banks’ overall deposit base the same.
This is why RBI has to either boost reserve money via OMOs or pump up the money multiplier via CRR cuts.
The author is Head of India Research at CLSA