By: Punam Sharma
The RBI cut repo rate by 25 bps today. The move per se wasn’t unexpected, given the Governor’s earlier guidance of possible rate action early in the year including outside of policy dates. Indeed, the buzz post the recent inflation prints was quite strong of a rate cut sooner rather than later. The surprise if at all is only that the market never thought of RBI as morning people! The accompanying statement preserves the earlier continuity noting the falling inflation momentum, some reduction in households’ inflation expectations, and the government’s continued reiteration that it is committed to meeting its fiscal deficit target. Conditions put forth for further easing include continuation of disinflationary pressures, sustained ‘high quality’ fiscal consolidation, as well as steps to overcome supply constraints and assuring availability of key inputs such as power, land, minerals, and infrastructure.
The most important takeaway for us is the signaling effect of this rate cut. The RBI has repeatedly stated, including today, that once the policy stance shifts it will signal a definitive shift and further actions will be consistent with the new stance. Thus the commitment to the changed regime is, in some sense, much more than when rate changes have been done previously. This is largely why the central bank has resisted calls for cut till now. This is also the reason why one can reasonably assume that the RBI now has strong levels of conviction of comfortably meeting its 6% target by January 2016.
We are in full agreement with RBI’s inflation assessment. As we have noted before (please refer “Macro and Bond Market Perspectives for 2015”, dated 6th January for details), there seems to be enough visibility of CPI averaging at least 5.5% in the year ahead. Given a 1.5% – 2.5% ‘real’ rate target, this provides visibility of at least a 50 bps rate cut; 25 bps of which the RBI has delivered today. However, it is instructive to examine whether the quantum of rate cuts over the next 12 months can be even deeper. While making this examination one must remember the fundamental underlying construct that has two moving parts: One, average CPI forecasts. Two, where between 1.5 – 2.5% does RBI want real rates to be. We examine these two parts in greater detail below:
1. The total build up in inflation over last calendar year (sum of month-on-month changes) was a shade less than 5%. However, the initial two prints in this calendar were flattered by the reversal in the excessive spike in vegetable prices that had happened late 2013. Adjusted for this, the total build up would have been approximately 5.8%. It must be remembered that 2014 also struggled with a sub-par monsoon. Hence, as a base case, one can reasonably expect at least the same momentum build up in the current year. Over this one must account for the effect of lagged changes. Rural wages and MSP settings continue to print early single digit growth. The lagged impact of these should continue to show on CPI going forward. Also, very importantly, the collapse in international commodities is a relatively recent phenomenon and is yet to pass through fully into domestic inflation (for instance, via fall in transport cost into milk and vegetable prices). Finally, the effect of new initiatives like the price stabilization fund and reformatting of Food Corporation of India (FCI) is yet to show through. All told, we will be watchful for inflation build up falling towards 5% for the calendar year ahead. Hence, inflation undershooting 5.5% average for the year ahead is one reason why cumulative rate cuts can exceed 50 bps.
2. The objective of positive real rate setting is ultimately to achieve financial stability. A higher quantum of funds disequilibrium (demand for funds exceeding supply) argues for higher real rate settings in order to incentivize savings. Conversely, if funds disequilibrium is seen as falling, the RBI can possibly settle for the lower end of its 1.5% – 2.5% implicit real rate target. As we have explained previously, the two practical indicators of funds equilibrium are the current account deficit (CAD) and banks’ credit to deposit (C/D) ratio. From 4.8% of GDP in 2013, CAD is expected to fall towards 1% of GDP in the year ahead. The full saving on oil imports will only show through starting now, although one must assume some pressures from further export slowdown and from recent rise in non-oil and gold imports. Looked at another way, net FDI alone will cause us to run a balance of payment (BoP) surplus of USD 5 – 15 billion even if all other flows (including FII) were nil. Thus India’s vulnerability to global pressures, barring short term portfolio readjustment effects, is now considerably diluted. A similar story on funds equilibrium emerges from examining the C/D ratio of banks. There seems to be no pressure whatsoever on deposit rates even in the so-called ‘busy’ season on credit. Even going ahead, economic recovery is unlikely to be credit intensive in the next few years and will have to rely on improving capital productivity instead. Furthermore, initiatives like Jan Dhan Yojna, Kisan Vikas Patra, etc will likely improve the financial savings net overtime. Hence, improving funds equilibrium leading to RBI settling for the lower end of its real rate target is another reason why cumulative rate cuts can exceed 50 bps.
Finally, a word on fiscal. A lot has been made lately of the government’s intention to dilute its 3.6% target for the year ahead. Provided this is done within limits (that is the government still adopts a better than this year’s 4.1% target) and provided the extra expenditure is not geared towards consumption, we don’t think this will change RBI’s reaction function. The RBI, as mentioned in its statement today as well, is focused on ‘high quality’ fiscal consolidation. Evidence so far points to the government delivering on this ask. The government has hiked indirect taxes on petro-products thus diluting the consumption effect of falling crude oil prices and also rolled back excise duty exemptions on durable goods. It has persisted with lower MSP settings and seems committed to achieving lower rural inflation. There is even talk of additional ‘cess’ on petro products to fund road infrastructure. Thus all evidence, so far at least, points to an effort towards shifting incremental resources from consumption to investments; an exercise that is bound to sit well with the RBI.
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