Unless RBI steps up OMO, interest rates won’t fall
With retail inflation staying under control in February—it dropped 50bps to 5.2%—and factory output contracting for the third consecutive month in January, there is enough of a case for RBI to ease the repo rate. What has made the case more compelling is that the government has promised to rein in the fiscal deficit at 3.5% in FY17—the central bank has made it clear it believes fiscal discipline is important and necessary to facilitate monetary easing. On the inflation front, food prices have corrected with a lag—they typically fall in December and January—but pulses, although softening, contribute almost 1 percentage point to headline inflation, way over the long-term average. While it is too early to predict the outcome of the monsoon, the recent unseasonal rains will impact the wheat crop, albeit in a limited fashion. Though water levels in reservoirs are about 26% below normal, it is important to keep in mind food inflation has remained under control despite two successive drought years. And while core inflation remains sticky, as HSBC economist Pranjul Bhandari points out, only 44% of the items in the core basket are clocking a price rise of more than 5%.
While RBI may trim the repo by 25bps to 6.5% in its next policy, how soon interest rates will fall will depend upon many things. Bank of America’s India economist Indranil Sengupta argues this will happen only when the credit gap is positive; right now, the credit gap is negative as loan supply has been constrained by slow reserve money expansion. Reserve money (adjusted for repos) has grown only 7.2% yoy as delayed OMO (Open Market Operations) and buybacks have not been able to compensate for portfolio outflows—Sengupta argues that, if $13 billion of FCNR (Foreign Currency Non-Resident) deposits are withdrawn on maturity, RBI will need to step up OMOs to R1.8 lakh crore from R1.2 lakh crore in FY16. As a result of tight liquidity, real lending rates are stuck at a 20-year high. While the 10-year benchmark yield is now at 7.6%, having hit a six-month low last week, it was nudging 8% not so long ago. Although the government has restricted its borrowings to R4.3 lakh crore in FY17—less than the amount expected by the bond markets—demand from banks may remain subdued, given there is already excess SLR in the system and deposit growth has been just around 11-12%. Moreover, government entities such as IRFC and NHAI will be looking to mop up funds around R60,000 crore from the market. That apart, state governments, who turned out to be big borrowers this year—tapping the markets for an additional R70,000 crore—could well be back next year asking for more. Unless there is a significant step up in liquidity through OMOs, increased government spending or through FPI inflows, rates may not fall by much. How much banks will pass on of the rate cut will also depend upon how much more provisioning they have to do, thanks to RBI’s accelerated NPA-recognition plan, though the new marginal cost lending norms will help.