RBI took the right call—monetary policy must move in tandem with fiscal policy.
With the Indian economy growing at its fastest pace in almost two years in the January-March period—despite the recent increase in inflation, a spike in crude oil prices and the resultant broad-based impact on prices—RBI was largely expected to hold key rates in the June policy. However, almost half the economists expected RBI to raise the repo rate to maintain financial stability, and contain second-round inflationary impact from higher oil prices, hardening inflation trends reflected both in headline and core CPI inflation for April 2018, a weaker rupee, rebound in the Q2 in the US economy, robust domestic economic growth and reviving investment growth, and the wage-price setting process due to the closure of output gap. The move could also have been driven by the action of other central banks in emerging markets like Turkey, the Philippines and Indonesia to combat rising inflation and weakening of their currencies with rising interest rates in the US and elsewhere, a strong dollar and outflows. In March, China raised a key short-term rate after the US Fed hiked rates.
India’s benchmark 10-year sovereign bond yields rose to their highest in two weeks to 7.9% on June 4, on expectations of RBI raising interest rates to keep inflation in check. Also, the two-month overnight indexed swap (OIS) rate, suggestive of future rate action, remained at close to a more than two-year high, signalling that RBI may increase policy rates. No wonder, then, the debt market had already priced in a rate hike.
In this overarching context, RBI decided, after “a prolonged pause,” to hike policy rates by 25bps while maintaining a neutral stance. Consequently, key policy rates stand adjusted—the repo rate at 6.25%, reverse repo at 6% and Marginal Standing Facility (MSF) at 6.5%. RBI’s six-member Monetary Policy Committee (MPC), headed by Governor Urjit Patel, unanimously hiked the repo rate. This hike is likely to increase both the rate of interest on deposits and advances, particularly rate-sensitive advances such as home and car loans. However, with RBI increasing the housing loan limits for priority sector loans to Rs 35 lakh from Rs 28 lakh in metropolitan centres and to Rs 25 lakh from Rs 20 lakh in other centres, housing loans are certain to become cheaper.
The case for a rate hike stemmed from faster economic growth in the January-March quarter to 7.7%, which is almost two-year high, and the rise in inflation—both retail and wholesale price—because of higher fuel and food prices in April. Retail inflation rose to 4.58%, after consecutively easing for three months, while wholesale inflation rose to 3.18% in April. This was the sixth consecutive month in which retail inflation level exceeded RBI’s medium-term target of 4%. Core inflation, mainly reflecting higher manufacturing prices, reached 5.9%, or a 44-month high. Given the underlying trends in inflation and financial markets, the MPC justifiably took this conscious call.
RBI revised upwards the retail inflation range to 4.8-4.9% (4.7-5.1% previously) in the first half of 2018-19, and 4.7% (4.4% previously) in the second half. It includes the impact from House Rent Allowance (HRA) for central government employees, with an upward bias. Uncertainties such as global financial market developments, monsoon, crude oil prices, MSP hike, state fiscal conditions and significant rise in household inflation expectation could feed into wages and input costs, and, thus, exacerbate inflationary pressures. Accordingly, India’s high consolidated gross fiscal deficit and current-account-deficit-to-GDP ratios could make it vulnerable to the negative sentiment characteristic of other emerging markets. India’s low external-debt-to-GDP ratio and high import cover may act as a buffer.
The rupee has depreciated by almost 3% in the last two months, and also breached the psychological `68 to a dollar barrier. Oil price hike along with negative FPI flows have contributed to this fall. There are some expectations of capital inflows and dollar selling by foreign banks, helping the Indian currency to cut some early losses. Forex market sentiment remained depressed because of India’s services sector activity contracting for the first time in three months in May, as new business orders stagnated and cost pressures intensified amid higher fuel prices. Meanwhile, net investment by FIIs turned positive after a protracted bout of selling.
GDP growth for 2018-19 is retained at 7.4% as in the April policy. The CRR and SLR have been retained at their earlier levels of 4% and 19.5%, respectively. At present, banks have excess SLR of almost 8%. With improving capacity utilisation and credit offtake, investment activity is expected to grow at a fast clip.
In February this year, RBI had allowed GST-registered MSMEs, with credit facilities of up to Rs 25 crore, up to 180 days (as against 90 days) to repay loans without being classified as NPAs. In a welcome move, RBI decided to “temporarily allow banks and NBFCs to classify their exposure, as per the 180 days past due criterion, to all MSMEs with aggregate credit facilities up to the above limit, including those not registered under GST.”
Since raising the repo rate in January 2014 to 8%, RBI either reduced it or maintained status quo, thereby inducing banks to reduce their rates so that capital and financial markets had enough cash to lend on lower rates.
It is likely that interest rates will continue to firm up; several major banks including SBI, PNB, Bank of Baroda, ICICI Bank and Kotak Mahindra Bank have raised their interest rates on home loans, car loans and personal loans by 5-20bps over the last four months in a synchronised manner. Many banks have also increased deposit rates. Hence, in view of the evolving macroeconomic situation and the growth-inflation trade-off, RBI took the right call in hiking the policy rate for the first time in the last four-and-a-half years. In the ultimate analysis, however, monetary policy must move in tandem with fiscal policy to support growth and employment.
By Manoranjan Sharma, General Manager, Canara Bank. Views are personal