A constantly changing growth and inflation nexus, and delays in monetary transmission, suggest the rate decision in the upcoming RBI policy meeting on October 5 should be assessed over a multi-year horizon. It is not just the rate of GDP growth, but also its constituents, that matter; it is not current inflation, but inflation forecasts one year down the line that matter. If rural demand is an important driver of current growth, then higher currency in circulation and a need for RBI OMO purchases will be a by-product.
If private capex picks up once election-related uncertainty eases, the saving-investment identity suggests the current account deficit (c/a deficit) may come under renewed pressure. If food inflation was surprisingly low in 2018, base effects could push it up next year. Conversely, if core inflation was high in 2018, base effects may limit its rise despite higher oil prices and a weaker rupee. And for an RBI that needs to juggle rate hikes with liquidity infusion, keeping a neutral stance, despite a series of rate hikes, may well be justified. CPI inflation is forecasted to rise from 4.5% in FY19 to 5.1% in FY20.
We expect RBI to hike the policy repo rate by 25 bps in the upcoming policy meeting, taking it to 6.75%. Expect another rate hike in the December meeting, before RBI goes on a prolonged pause. Growth has been strong this year, even after accounting for a low base (c8% on both a y-o-y and q-o-q annualised basis).
This has been led by a mini revival in rural India and, to a smaller extent, by a gentle revival in exports. Four things matter for rural wages: Recent inflation experience (higher inflation leads to more bargaining power), minimum support prices (MSPs), reservoir levels and construction activity. By elimination, construction activity is the main driver of wage growth. In fact, non-agricultural wages are rising sequentially, pulling up agricultural wages. The rural revival is largely government sponsored, both directly and indirectly. Rural ministries are the highest spending ones on-budget.
Alongside this, NABARD has increased its market borrowing, leading to a rise in the off-budget spend on the sector. This rural revival has some interesting takeaways for RBI. Firstly, the rise in off-budget spending implies that the de-facto fiscal impulse is higher than on-budget estimates suggest. It may even partly explain why government bond yields remain elevated, despite a lower on-budget borrowing calendar.
Secondly, whenever rural growth outpaces urban growth, currency in circulation rises at a faster pace, requiring higher OMO purchases from RBI. India’s non-oil goods exports fell by 0.6% of GDP last year. But with improvements in the GST IT network and more timely refunds, goods exports are likely to perform better this year.
In addition, the ongoing depreciation of the rupee is likely to make services exports more competitive over time. However, the rapid rise in imports is likely to offset all of these gains in exports (even if the rate of deterioration is lower than last year). Any meaningful improvement, in HSBC’s view, can only come from structural reforms, particularly in exports. In some sense, all of this is the story of yesterday. The next few quarters are likely to be marked by some moderation in activity (from 8.2% y-o-y GDP growth in Q1FY19 to sub-7% by Q4FY19).
Higher oil prices are likely to raise the cost of production, while tighter financial conditions are likely to raise the cost of credit. If prolonged, concerns around the liquidity situation of India’s shadow banking system could hurt urban consumption and construction. Finally, growth, historically, falls sharply in the run up to national elections. In fact, analysis suggests private capex falls the most in the quarter just before national elections (which would be the January-March, Q4FY19 quarter, assuming elections are held by May 2019). However, once elections are over, private spending tends to rise sharply.
This may also be the period when growth dividends from reforms such as GST start flowing in. And herein lies the good news. While GDP growth may not rise quickly next year, its quality is likely to improve over the next few years; from government sponsored currently, to private sector and reforms led. However, there will be two big challenges along the way. Firstly, higher investment in the second half of 2019 may lead to a wider c/a deficit. The c/a deficit is, after all, just investment minus savings and if investment rises with no change in savings, it simply widens further. The policy prescription is straightforward.
Raise real rates to encourage financial savings. Secondly, inflation may be elevated for much of 2019, and not just because of higher oil prices. Thanks to improvements in supply and supply logistics, so far in 2018, food inflation has offset pressures from core prices, but a low base in food inflation could become a problem for much of 2019. Since the weight on food inflation is higher than that on core, headline inflation is likely to rise next year.
With inflation averaging 100 bps more than the 4% target for much of FY20, expect RBI to remain vigilant. And because monetary transmission works with a 2-3 quarter lag, rate hikes should be done sooner rather than later. Under RBI’s neutral liquidity regime, it needs to replenish ‘durable’ liquidity leakage with ‘durable’ liquidity injection.
One could argue that the recent announcement of liquidity infusion (of Rs 360 billion in October) sits oddly with RBI, which has recently hiked the repo rate and is likely to do so again. After all, in standard theory, rate hikes are transmitted best when liquidity is tight. But, perhaps not necessarily so.
But, rate hikes to control inflation, and OMO injections to keep liquidity at neutral (to support genuine growth needs), can co-exist, and have done so before. Expect liquidity to tighten from October onwards due to a combination of rural revival, ongoing RBI foreign exchange intervention, the seasonal increase in currency in circulation that is observed in the second half of the year, and the seasonal build-up of government cash balances towards the end of the year. Consequently, expect RBI to do a series of monthly OMO purchases over the remainder of the fiscal year.
In HSBC’s view, the reason RBI did not tighten its stance in the last two policy meetings could have been precisely because it wanted to keep all options on rates and liquidity operations open in order to cater to the evolving requirements of the economy. In an environment where there are more questions than answers on the future of world growth, oil prices and trade wars, it is not unreasonable for RBI to keep its stance neutral despite delivering rate hikes. In fact, it gives the right message that RBI is watching, and is ready to move either way, as and when needed.
Edited excerpts from HSBC’s India RBI Watch, published on October 3, 2018.
Report was co-authored by Aayushi Chaudhary and Dhiraj Nim.