Policy status quo for now, but normalisation to begin 4Q 2021. RBI’s assessment of the second wave impact on Q2 GDP growth too pessimistic; inflation persistence is a risk
By Sonal Varma & Aurodeep Nandi
RBI’s latest policy actions are on expected lines—keeping all three levers—rates, stance and forward guidance unchanged and dovish, while relying on G-SAP as a tool to communicate further accommodation and to prevent any premature tightening of financial conditions. The regulatory measures aimed at opening the liquidity spigot for sectors most affected by the second wave are also on expected lines. It also suggests that growth is a priority, inflation is likely to be transitory and hence the MPC is not thinking about policy normalisation—very similar to statements from other central banks globally. The policy choices reflect RBI’s uncertain view about the growth outlook under the second wave and the need to keep borrowing costs under check, all while being acutely aware of rising inflationary pressures amid already low policy rates.
How the macro scenario is likely to play out hereon
We agree with RBI’s broad assessment on growth and inflation, but there are nuanced differences. On inflation, upside risks are building and it is not clear to us whether inflation is “not persistent”. Higher global commodity prices have led to rising industrial input costs for manufacturers, and rising gasoline prices. The second wave also brings with it idiosyncratic pressures due to be demand-supply mismatches, as evident in elevated health costs and the faster build-up of rural wages. While we agree that inflation is supply-side right now, this may change. As the second-wave drag subsides, vaccinations progress and growth recovers, we expect demand-side pressures to emerge as firms look to pass on increased input costs onto consumers to protect their falling margins, with services price inflation receiving a boost from the re-opening. RBI’s survey shows that urban households inflation expectations are drifting higher. Hence, we expect headline inflation of ~5.0% in FY22, in line with RBI’s forecast, with upside risks building for core inflation. We do not see inflation drifting back to the midpoint target of 4% even in 2022; it appears to be stabilising around 5%.
On growth, we agree with RBI that the second wave impact will be confined to Q2 (Apr-June). The economy has escaped the worst of the second wave’s economic hit, as mobility is bottoming out, and states are cautiously reopening. Early data for the worst-hit month of May largely seem to confirm our view that the impact of the second wave should be far less deleterious than the first wave, with our analysis suggesting that there is a bigger impact on consumption and services, with manufacturing and the export sector holding steady. Moreover, the rising pace of vaccinations, strong global growth and the lagged impact of easy financial conditions should keep India’s business upcycle intact, even though the virus remains a risk in the near months. However, RBI’s downgrade of its Q2 (Apr-Jun) GDP growth forecast to 18.5% y-o-y (vs 26.2% earlier) is too steep, in our view. It builds in a GDP contraction of over -12.5% q-o-q, sa, on our estimates, which is significantly bigger than our baseline (-3.8%). Based on international evidence and high frequency data, we believe this is too pessimistic and expect a positive surprise when Q2 GDP data are released at end-August. We expect GDP growth of 9.8% in 2021 (10.8% in FY22), above RBI’s projections.
Fleeting policy space
In our view, RBI is juggling multiple objectives—support growth with ample liquidity, manage long-term yields, while keeping an eye on inflation. The policy hand-eye coordination however is becoming increasingly complicated, as the second-wave hit to growth comes at a time of rising inflationary pressures. Moreover, in a health crisis, there is limited monetary policy efficacy beyond a point. Lower interest rates and higher liquidity will do little to support growth, if lenders and borrowers remain inherently risk averse. The primary tool is fast tracking the health policy response via faster vaccinations, while monetary policy plays a supportive role. Hence, monetary policy at this stage remains hostage to the government’s vaccination policy.
Timing is also tricky. Unwind too soon, and financial conditions may tighten and jeopardise the recovery. Normalise too late, and the risk of unhinging inflationary expectations may eventually call for harsher remedial action by RBI. Meanwhile, with inflationary pressures rising globally and Fed tapering likely in the medium term, there is also a risk of a sudden tightening in external financial conditions, although the RBI Governor’s statement that India’s FX reserves have reached $600 billion suggests that these will be used to guard against any global spillovers.
In our view, RBI is likely to retain its accommodative policy stance and stay on hold for the foreseeable future by assigning a higher weight to growth over inflation, amid the pandemic uncertainty. However, we expect the weight assigned to inflation to rise as the year progresses, as domestic growth recovers in the coming months, growth uncertainty wanes and inflationary pressures remain elevated. We expect discussions on policy normalisation to begin later this year and maintain our baseline view of a reverse repo rate hike in Q4 and 50bp of repo rate hikes in H1 2022.
India rates moved higher following RBI meeting, with a fairly large steepening in the NDOIS curve (1y +1.5bp, 5y +7bp). Front-end rates are more anchored as RBI said growth remains a priority and it is not contemplating policy normalisation for the moment. However, the long end of the curve is more reactive to the prospect of eventual policy normalisation as the Covid-19 situation stabilises. The announcement of Rs 1.2trn of GSAP 2.0 to be implemented in the Jul-Sept period was close to market expectations. However, with some upside risk to bond supply in FY22 (to compensate states for the GST shortfall during the second wave) and RBI suggesting the 6% 10y G-sec yield is not sacrosanct, there could at the margin be slightly higher volatility in the 10y bond yield.
Overall, while we continue to believe ‘carry’ is likely to prevail in the near term if RBI stays accommodative, there is room for the market to gradually price back a faster pace of policy normalisation, as the market currently only prices a fairly modest pace of normalisation (overnight MIBOR to move back to repo policy rate in April 2022, followed by a 50bp policy rate hike for the remainder of 2022). We recently reduced our NDOIS flattener exposure from 1s3s to 2s3s. We are maintaining the position as the 2s3s part of the NDOIS curve remains steep relative to the rest of the curve. However, our preference is to gradually move to a pay exposure at better levels.
On the rupee, RBI has signaled a dovish stance and is focusing on growth, which is unlikely to support the rupee in the immediate term. Indeed, it could even be taken as a slight negative for the rupee in that some may believe RBI prefers to keep rupee relatively weak to support its growth drive. That said, we are not overly concerned for several reasons: 1) recent weekly adjusted FX reserves data continue to show limited action from RBI in spot (average weekly adjusted + $1.3bn in the past four weeks to 21 May) despite rupee appreciation; 2) Governor Das highlighted RBI’s ample reserves to manage external shocks and raised concerns about reserve accumulation and the impact on liquidity/monetary policy (the impossible trinity) and; 3) a policy stance that is growth supportive, along with an improving global backdrop should still see capital inflows and rupee appreciation pressures emerge (as experienced since end-April 2021).
We currently remain short USD/INR in small size (around 25% of our desired risk), but it may be possible to add in this direction after the upcoming June 16 FOMC meeting in view of the possibility that US Fed talk of tapering is increasingly being priced in.
Edited excerpts from Nomura Global Markets Research’s Asia Insights report dated June 4
Varma is chief economist, India and Asia ex-Japan, and Nandi is India economist, Nomura