We expect the RBI MPC to cut policy rates by an additional 100bps in FY21 in our base case of 6% GDP contraction
By Indranil Sengupta & Aastha Gudwani
We continue to expect the RBI MPC to cut policy rates by 25bps on August 6, in a close call, and another 75bps in FY21. Why? The Covid-19 shock is set to contract GDP by 20% in the June quarter and 6% in FY21. Second, while CPI inflation, at 6.4% (BofAe) in July, would exceed RBI’s 2-6% mandate, this is driven by supply-side disruptions and methodological issues. With fundamental drivers weak, it should slip to 2.5% in H2FY21. Third, high real lending rates still delay recovery, beyond the Covid-19 shock. Fourth, time is running out with the ‘busy’ industrial season commencing October. Fifth, rising M3 growth, at 12.4%, constrains RBI from trying to contain yields through quantitative easing as freely as in the past. It is for this reason we expect RBI to extend HTM to the additional borrowing of 4% of GDP/5.3% of NDTL. Finally, adequate FX reserves would provide room for RBI to cut rates and support recovery. In his last RBI MPC minutes, Governor Shaktikanta Das reiterated “…the RBI shall not hesitate to use any conventional and unconventional tool … to revive the macroeconomy and preserve financial stability while adhering to the inflation target.” In 2003, then-Governor Bimal Jalan eased to revive growth looking through high inflation due to a drought. That put India at the head of global recovery.
Given rising fiscal slippage, RBI could either indicate an OMO calendar or extend HTM on additional borrowings to banks. Finally, FM has indicated that one-time settlement (OTS) of bad loans is under consideration.
We expect the RBI MPC to cut policy rates by an additional 100bps in FY21 in our base case of 6% GDP contraction; 25bps cut on August 25, followed by 50bps in October and 25bps in December. In bear case of 7.5% GDP contraction, we see 200bps RBI rate cut.
The Covid-19 shock is expected to contract GDP by 20% in the June quarter and 6% in FY21. BofA India Activity Indicator points to GDP contraction as well. GST collections are also down 14.4% in July atop a 39.6% decline in the June quarter. This assumes that current unlock restrictions extend to mid-November with restart taking six weeks to December. A month of lockdown would cost 100bps of annual GDP. Given labour dislocations, our expected six weeks of restart will cost 120bps.
CPI inflation should slip to 2.5% in H2FY21 from 6.4% BofAe in July as methodological issues and supply-side disruptions iron out. Fundamental drivers remain weak: GDP contraction, good sowing, low ‘imported’ inflation and limited fiscal slippage relative to the massive growth shock. Although CPI inflation remains high, WPI, which measures corporate pricing power, has deflated by 1.8% in June.
CSO’s CPI methodology: The CSO’s imputation methodology resulted in significantly high numbers for April and May. To address the non-availability of data for several subgroups during April and May 2020, CSO has undertaken an exercise for imputing missing sub-groups/groups by using next level up the index, i.e.
groups/general CPI calculated with the observed price during the lockdown period. Under this exercise, ‘Food & Beverages Group Index’, calculated on collected prices, is used for imputing the index the sub-groups of the food & beverages group. Similarly, for the general CPI, calculated on the basis of the sub-group indices where data was available, was used for imputing the indices for the sub-groups/groups other than ‘Food & Beverages’ where price data was not captured. The imputation approach used the following formulae:
Imputed Sub-group Index (Food Group) = (Last Observed Index of Sub-group) x (Food Index of Current Month/Food Index of last Observed Month) Imputed Sub-group Index (Non-Food Group) = (Last Observed Index of Subgroup) x (General CPI of Current Month/General CPI of last Observed Month).
The fundamental drivers of inflation remain weak
Good rains to contain agflation: The south-west monsoon is expected to be normal in 2020 and rains so far are in line. This has pushed autumn kharif sowing up to 13.9% with 83% of total area sown already. The Met sees good 97% of normal rains in August. A growing wedge between CPI and WPI food inflation underscores our point that the jump in CPI food inflation is due to a temporary supply shock.
Low ‘imported’ inflation: Our oil strategists see dated Brent price at $44.3 in 2020 (versus $60/bbl in FY20). RBI’s $45 billion FX intervention (BofAe, $27.8 billion done so far) should contain depreciation.
Limited fiscal slippage: We see the central government’s fiscal deficit at 7% of GDP for FY21 BofAe, 350bps higher than the government target. While this is above the 4.5% long-run average, growth is 13%-plus below potential.
High real lending rates still delay recovery beyond the Covid-19 shock. While nominal MCLR has come off by 105bps since March 2019, real MCLR has gone up by 44bps. Similarly, average nominal lending rates have come off by 37bps since March 2029, but real lending rates went up 147bps. Not surprisingly, credit flows are far lower in 2020 than 2019.
Time is running out with the ‘busy’ industrial season beginning October. As loan demand picks up seasonally, the transmission of RBI easing would become far more difficult.
Rising M3 growth, at 12.4% versus our 9.1% optimal, constrains RBI from trying to contain yields through non-interest rate measures like OMO. Hence, we expect RBI to extend HTM to the additional borrowing of 4% of GDP/5.3% of NDTL as well as buy FX $17.2bn (BofAe) forward.
High FX reserves provide room for RBI to cut rates and support recovery. We estimate that RBI can sell $50 billion to defend the rupee. Of note, RBI action to support growth should attract FPI equity flows.
Authors are India economists, BofA Securities. Views are personal
(Edited excerpts from BofA Global Research’s India Economic Viewpoint: Six reasons for likely RBI rate cut on Thursday report, dated August 3)