RBI stress on CPI suggests more rate hikes likely
RBI Governor Raghuram Rajan has excited the markets since, apart from finally winding up the huge MSF rate hike by his predecessor, he has increased liquidity through term repos at the short end of the market. This means, for now at least, the 25 bps repo hike will not translate into higher lending rates. Apart from helping complete the yield curve—important for a corporate debt market to evolve—Rajan also reiterated his plan to complete “missing markets”. Banks are to be allowed to give partial credit enhancement to corporate bonds though it is unclear how this is to work since giving guarantees has been ruled out—detailed guidelines on how this can be done by way of credit and liquidity facilities are to be issued later. While interest rate futures are an important step in terms of helping corporates hedge risk, allowing them to be settled in cash means the chances of them taking off this time around are brighter. Though it remains to be seen whether foreign banks will convert to wholly owned subsidiaries given the promise of them getting ‘near-national treatment, including in the opening of branches’, the BSE Bankex rose an inexplicable 4.4% on hopes of greater mergers and acquisitions as well as easier liquidity and the return to the traditional MSF-repo corridor. While there is little to suggest Governor Rajan is correct in surmising that falling real rates of interest—due to inflation inching up—had caused an erosion of financial savings, investors are certain to lap up the new CPI-linked National Savings Securities, though there is no clarity on the size of the issue.
Despite all the promise and the larger game-plan, the problem with Tuesday’s monetary policy is the greater emphasis on the CPI and the diminution in the role of WPI as an indicator—indeed, given the rupee has stopped its downward plunge, the pressure on WPI is all set to further reduce, logically suggesting a pause in repo rates. Though Rajan was at pains to say RBI had always kept CPI in mind, it seems odd that as late as August 30, his predecessor D Subbarao pointed out that the new CPI had just 19 data points which was nowhere near sufficient for it to be used as a variable to decide policy. Rajan has defended using CPI on grounds it includes services while WPI does not. But WPI includes services that businesses use and not only is it well under control, it correlates closely with the GDP deflator that takes into account all activity in the economy. The problem with using the CPI, the flaws in which have been the subject of several columns in this newspaper, is that it raises the chances of another rate hike soon—more so when you keep in mind the serious supply shortages in fruits and vegetables that are driving it up. In an economy where consumption and investment have been falling for several quarters in even nominal terms—consumption fell from R15.5 lakh crore in Q3FY13 to R14.1 lakh crore in Q1FY14 while investment fell from R8.1 lakh crore in Q4FY13 to R7.2 lakh crore in Q1FY14—the last thing the economy can afford is a rate hike. More so, given 45% of all investment in the economy came from the household sector in FY12.