By Saugata Bhattacharya

We had expected the MPC to continue with its accommodative stance and RBI to hold the reverse repo rate, although the latter was a close call given the evolution of the ‘growth vs inflation’ dynamics. This didn’t turn out to be the case. The surprise was the continuing dovish guidance and communication (even as one MPC member continued with a dissent on the stance). What might be the reasoning?

The economic forecasts suggest that MPC assesses that the output gap is still negative and that aggregate demand still needs policy support. FY23 GDP growth is projected to be 7.8%—on the lower side of analysts’ forecast band and lower than our own 8.3%, the Economic Survey’s 8-8.5% and certainly the IMF’s late-January estimate of 9%.

Yet, this is consistent with the Budget’s 11% nominal growth assumption. One of India’s growth engines—exports—is likely to record a moderate showing compared to FY22, given an expected slowdown in global growth and especially trade, as per both IMF and WTO forecasts. China’s growth is expected to slow even more. But, this might get somewhat offset by the higher capex planned by the Centre and possibly, due to the incentives and funds offered, by the states as well. As the public health situation improves, pent up demand might also result in higher spends, particularly in contact services. The resultant revival in activity and capacity utilisation might also spur private capex. The release of RBI survey results will provide more clarity.

In addition, due to the restrictions-led deceleration of economic activity in Q4FY22, it is likely that growth will come off slightly from the first official Advance Estimate of 9.2%, boosting FY23 growth a little.

On the other hand, RBI’s 4.5% FY23 CPI inflation forecast seems slightly conservative, considering the risks, both domestic and global. Even if crude oil prices fall from the current levels, they are likely to average higher than in FY22. Prices of some metals—copper, aluminium, etc—are rising. China’s policy stimulus is likely to add to the recovery-led demand in many developed markets. So will, as noted above, India’s own domestic demand. Preliminary forecasts suggest La Nina conditions likely to persist in the southern hemisphere, which is usually good for a normal monsoon, but it is still too early.

Another consideration underlying the dovish guidance is probably an implicit support for the Centre’s (and likely states’) large borrowing programmes. Benchmark government securities’ yields have risen sharply since the October review’s withdrawal of the GSAP purchases, and recently, the Centre’s higher than expected borrowing programme. Although yields have fallen with the cancellation of an auction, the underlying concerns of a demand-supply mismatch is still likely to push yields higher when the borrowing calendar resumes in Q1 FY23.

The worry is the hypothesis that RBI might be “falling behind the curve” in the normalisation cycle. What exactly does this mean? Most of the G-10 global central banks have announced, with different degrees of emphasis, a tightening of their respective monetary policies. The Federal Reserve in particular—given the tightness of labour markets in the US—has been aggressive in signalling the pace of rate increases and subsequent Quantitative Tightening (QT) by extracting the liquidity overhang.

Even the most dovish ones are signaling an eventual hiking of their policy rates later in 2022. This will likely have spillover effects into emerging markets, including India, particularly through the portfolio capital flows channels, as investors re-balance their portfolios.

It is in this context that RBI’s de facto tightening of money markets assumes significance. The “the effective reverse repo rate (ERR rate)”—the weighted average of the fixed rate reverse repo (RR) and the variable rate reverse repo (VRRRs)—has increased from 3.37% at end-August 2021 to 3.87% in early-February 2022 in a remarkably smooth move, conducted over a series of VRRR auctions. In addition, the move up in the ERR rate, combined with calibrated liquidity management operations, has also pushed shorter term funding rates (T-bills, Commercial Paper, bank Certificates of Deposits, etc.) up, close to the positive real rates territory.

To paraphrase the RBI Governor, since the RR rate represents the continuing accommodative stance, why change the actual rate when the intended de facto normalisation signal has been convincingly delivered? Added to this is the diminishing importance of the fixed rate RR operations, with a move towards VRRR auctions. So, why care about the RR rate at all

The problem is that a significant amount of the overall liquidity still resides with non-bank financial intermediaries like mutual funds, which have to use other channels like Treps and market repo to manage their positions. The rates in these markets are still at or below the actual reverse repo rate, and continue to be volatile. This has the potential to create some distortions in overnight and short-term rates while also creating ambiguities in RBI policy rate signaling.
This, in itself, need not create larger spillover risks from the likely divergence in policy rates trajectories of central banks, if India’s underlying growth, fiscal and external fundamentals remain robust. To an extent, they are; but there are still potential risks. RBI, in coordination with the government, has demonstrated the ability to manage the trade-off and maintain stability in financial markets during the last couple of years of severe stress. Yet, over the course of this year, divergences in both domestic and offshore policy actions are likely to accentuate, presenting challenges in managing the multiple, often conflicting, objectives.

Finally, credit from banks and other intermediaries will be a key pillar for supporting durable growth, particularly for MSMEs.
As the cost of funds rise, there will be some transmission into lending rates. This will need to be managed, and the Budget backstop initiatives will play an important role.

The author is Executive vice-president and chief economist, Axis Bank Views are personal