By Indranil Sen Gupta,
I recently turned dovish after two odd years of being a relentless hawk. I continue to expect the RBI MPC to cut by 15 bps on 8 April, if the Fed gets more dovish on March 20, and 100 bps by June 2025. After all, the real RBI repo rate is well beyond the 1% typically deemed adequate. What is changing? Governor Shaktikanta Das has himself said that the inflation fight is in the last mile. With the RBI reining in M3 expansion, not only is headline inflation close to the 5.5% growth-maximising ‘threshold inflation’, despite an agflation spike,but core inflation has dropped to low 3% levels.
Second, the Fed is set to cut 75 bps in 2024 and 100 bps in 2025. Finally, finance minister Nirmala Sitharaman has cut the FY25/FY26 fiscal deficit target to 5.1%/4.5% of the GDP to adhere to the government’s fiscal glide path.
I continue to expect the RBI MPC to cut the repo rate by 15 bps on April 5, if US core CPI inflation persists at 0.3% month-on-month (i.e., 3.6% annualised, implying a high 200 bps real rate) and provides greater clarity for the Fed on rate action in its March 20 meeting. After all, the real RBI repo rate (in relation to core inflation) is running at a very high 3.3%. Even after the recent jump in agflation, the real repo rate is still at about 1%, at a time US growth is set to slow. Taken at the RBI’s own 5% FY25 inflation forecast, the real repo rate works out to 2%.
I continue to worry about tight liquidity as it is driving up lending rates at a time a growth slowdown in the US can impact the Indian economy. While the nominal MCLR has gone up by 155 bps to 2019 levels, the real MCLR with respect to core WPI inflation has jumped by 1,007 bps since March 2022. After all, the liquidity deficit has arisen as the RBI has bought only about $15 billion of FX, while my estimates report a need for a $42 billion injection (ex 50% of Rs 2,000 notes) of reserve money.
The RBI appears to want to manage liquidity through repos as the government balances with it are substantial. Experience also suggests that credit/deposit creation then tends to be slower due to asset-liability mismatches. Furthermore, the bulk of this essentially comes from state governments’ surpluses (Rs 2.5 trillion).
Against this backdrop, I also expect the RBI to try to buy foreign exchange in the March quarter, especially as it has sold over $20 billion (including forwards) this fiscal. While our balance of payments estimate is that it should be able to buy about $10 billion in the March 2024 quarter, it remains to be seen how much of foreign portfolio investment actually comes in at lofty equity market valuations.
One is sometimes asked about the gap between deposit growth (12.4%, adjusted for HDFC deposits) and loan growth (16%). Relatively sluggish deposit growth essentially reflects the lower expansion of reserve money (9.8% adjusted for 50% of the Rs 2,000 notes demonetised). This begs the question: Isn’t a booming stock market resulting in a run-down of bank deposits for, say, mutual funds? Not really. When an individual purchases mutual fund units, all that happens is that money flows from his/her fixed deposit to the current account of the mutual fund. It is only when the individual turns to cash, small savings, or foreign exchange that there is a run-down in bank deposits.
I see three compelling reasons for the RBI to cut rates as soon as the dollar prices in Fed cuts to provide the headroom to act. Inflation is really yesterday’s story. The spike in vegetable price inflation is reversing on continuing government initiatives. Consumer affairs, food, and public distribution minister Piyush Goyal is arranging Bharat Rice, Bharat Atta, Bharat Dal, onion, sugar, and oil at affordable prices to consumers. January inflation should fall 40 bps to 5.3%, within the RBI’s 2-6% mandate. Core inflation is already a low 3.2%.
Finance minister Nirmala Sitharaman has surprised the market by embarking on faster-than-expected fiscal consolidation, despite general elections being just a couple of months away. She has cut the FY24 fiscal deficit target to 5.1% of GDP (vs the 5.5% we and consensus expected) and committed to meeting the 4.5% in FY25 planned in the fiscal glide path. This has correspondingly brought down the government’s net borrowing programme. With RBI rate cuts as well as inflows by debt foreign portfolio investors, I see the 10-year government bond yield easing to 7% in March 2024 and 6.5% in March 2025, assuming Rs 2.4 trillion of RBI open market operations in the next fiscal.
Won’t RBI rate cuts weaken the rupee when the differential with the US Fed is at a low 100 bps? I actually think that RBI rate cuts will support rather than hurt the rupee as the dollar prices in Fed cuts. The relationship between the RBI repo rate and the rupee is different for India than the corresponding case in other emerging markets. FPIs’ equity holdings are almost 15-20X those of debt FPIs.
RBI rate cuts support growth, attract FPI equity flows, and support the rupee. This, in turn, crowds in debt FPIs looking for capital/FX gains. Debt FPIs will surely take advantage of such an opportunity as they have to bring in about $21 billion after the Indian government paper’s inclusion in the JP Morgan EM Bond Diversified Index. The rupee should stabilise at 82 to the dollar, with the latter weakening to 1.2 to the euro by end-2024.
(The author is Economist and head of India Research at CLSA. Views are personal)