Tn June 2017, the Monetary Policy Committee (MPC) decided to hold the repo rate unchanged with neutral monetary policy stance due to prevailing uncertainties. However, there was no consensus among the MPC members, as one Member suggested a 50 basis points (bps) cut for the repo rate. The decision of the MPC to hold the policy rate in June 2017 was not well received by the stakeholders. The government was pitching for a rate cut well before the MPC meeting. Even expert like former RBI governor YV Reddy gave ‘benefit of doubt’ to the MPC for keeping the repo rate unchanged. Nobel Laureate, Paul Krugman in a recent interview indicated that India’s monetary policy is tight.
The defence to keep the repo rate unchanged is weakening by all counts. Uncertainty about the onset of south-west monsoon is over. India Meteorological Department (IMD) predicts a fairly good monsoon this year, which augurs well for the agricultural sector.
The central bank has already revised its inflation projection downward—2 to 3.5% in the first half and 3.5-4.5% in the second half of FY2018. Model-based inflation projections have upward bias in a declining phase of commodity prices and vice versa. Survey-based inflation expectations in India are mostly adaptive, and hence lack precision. The CPI data for May and June 2017, available after the last policy announcement, indicate further decline in inflation with the June CPI inflation being the lowest at 1.54% since its inception.
The CPI inflation is now below the lower bound of the inflation target. If another bumper crop is assured by the normal monsoon, price situation may soften further, much lower than RBI’s revised projection by March 2018. Moreover, certain segments of the economy like food and beverage, particularly pulses, oilseeds, vegetables, spices, eggs, etc, are suffering from deflationary pressures. The farmers’ unrest in many states is partly attributed to unremunerated prices of their products, well below the level of minimum support price (MSP).
As expected, a hike in the Fed Rate, which followed the announcement of RBI’s June policy, went off well without any disruption in global financial markets. The fear of capital outflow from emerging economies due to normalisation of the US monetary policy is diminishing.
India is currently a bright spot and attracts large capital inflows due to strong medium-term fundamentals. Encouraging debt flows through maintaining interest rate differential between India and the US is undesirable, at least at the current juncture. On the contrary, one can argue that India should refrain from encouraging arbitrage-driven portfolio flows as these inflows are volatile.
Crude oil prices have softened during the recent period notwithstanding sustained global recovery. At least, there is no threat to domestic inflation from abroad. The goods and services tax (GST) is a big-bang reform, which is under implementation. It has been acknowledged by RBI that the GST may not be inflationary despite possible glitches surrounding its implementation. Domestic prices may even soften in certain sectors, at least at the wholesale level, due to GST implementation.
Implementation of house rent allowance as recommended by the Seventh Central Pay Commission is under progress by the central government. State governments may have to implement these recommendations without further delay within fiscal discipline committed by them. Hike in the house rent allowance alone may raise the CPI inflation considerably. Even accounting for CPI inflation due to hike in house rent, the headline CPI inflation may remain well below the 4% target by March 2018. The relationship between government house rent allowance and the market rent is weak, particularly in the context of a large inventory build-up of unsold houses during the recent period. Policy makers can afford to see through some rise in CPI inflation for a while as it is a statistical artefact rather than true inflationary pressure.
Output gap continues to remain negative in India. It may not close so soon as capacity utilisation is much below 75% at the all-India level. Private investment is not forthcoming due to prevailing slack in the economy. On the other hand, the government has been spending large amount in developing infrastructure besides pursuing transformational reforms like GST, digitisation, etc. Foreign direct investment is sustained at an elevated level, which augurs well in improving potential output going forward.
India could not get maximum benefit arising out of yield compression in the post-global financial crisis period. Domestic yields of fixed income securities remained at an elevated level compared to many countries of the world. Recent narrowing of the policy corridor has further supported short-term rates at an elevated level. This has deprived the corporate sector from raising funds at cheaper rates by issuing commercial papers and other debt instruments.
Notwithstanding neutral monetary policy stance, liquidity conditions remain highly comfortable. Surge in deposits was mostly due to demonetisation vis-a-vis historically low credit growth. Large capital flows also contributed to comfortable liquidity condition. Easy liquidity condition suggests that switching over to easy monetary policy shall be seamless.
Big corporates prefer to borrow from abroad through ECB and issuance of masala bonds. This is not a healthy proposal as global interest rate cycle is due for a turnaround. As most of the external commercial borrowings are contracted at variable rates, corporates, exposed to large external borrowings, may have to face serious debt servicing problem if global interest rates pick up quickly. Corporates without natural hedge are more vulnerable going forward.
Cut in the repo rate may bring down at least short-term rates, which in turn may help firms depend on domestic markets for working capital requirement rather than look towards overseas funds. All eyes are on MPC Members if they can oblige by cutting the repo rate in August policy.
Barendra Kumar Bhoi