The credit policy announced was on expected lines, and, hence, there was no surprise. The repo rate was kept unchanged, and the stance kept neutral. Is there something that can be taken from the statement presented by the RBI?
First, the RBI has revised the GDP growth forecast for the year from 6.6% to 6.7%. On the face of it, this does not mean much, as there is hardly any difference between the two numbers. However, this is symbolic of the fact that notwithstanding the developments that have taken place in the global space in terms of war, the Indian economy is not expected to be buffeted in any way. The war has cast a shadow on the economic prospects of all countries, given that the actions of the USA happen to be quite unpredictable, being idiosyncratic. A related thought here is that if growth is on expected lines, there is nothing much to be done on the monetary side to prevent a downslide. Therefore, an unchanged repo looks appropriate.
Second, the RBI has also lowered its inflation forecast for the year from 5.1% to 5%. Here, too, it is quite marginal to be materially different from the June projection. But here the symbolism is that inflation will be lower than expected earlier, especially considering the fact that the monsoon has not exactly been very good and the area under cultivation for several crops is lower than earlier. Therefore, there is a signal that things will stabilise in the coming months, and no major danger is seen to the headline number. Hence, leaving the repo rate unchanged makes sense, as it is within the band of 4 to 5%.
Third, the inflation forecasts for the coming quarters are interesting. While the overall number has come down to 5.1%, the forecasts for Q3 and Q4 of this year and Q1 of next year would be above 5%. In fact, the Q3 number is expected to be 5.9%, which will come down subsequently to 5.4% and 5.3%, respectively. Now with inflation averaging 5.5% for 9 months, prima facie the number is in the band of 4-6% and does not necessarily warrant a rate hike. But if the repo rate is at 5.25% and inflation is 5.5%, the real return turns out to be negative, which is not good for the banking system, as deposits will move away to markets. Therefore, it stands to reason that there will be a rate hike in the coming months. Maybe October will be too early, as the inflation numbers available at that time may still not look ominous. December could be the time when a call may be taken. And depending on the trajectory of inflation, there can also be a second rate hike subsequently. The market indicators point to 2 rate hikes.
Fourth, the RBI has kept silent on the FCNR scheme and clarified subsequently that there were no intentions to have a premature closing to this scheme. The market was rife with speculation that the RBI may close the scheme earlier than September, as the flows have been very encouraging at around $40 bn in the first two months.
Fifth, the RBI has also not spoken about what would be done with the surplus liquidity in the system once the FCNR scheme ends. In fact, there are two parts to this. The first is the surplus dollars that come in, which can be now in the range of $60-80 bn based on various market estimates. Will the RBI build the forex reserves or use them for spot transitions to stabilise the rupee? Or will the RBI use them to pay off the forward book, which is maturing in the coming months, which could be upwards of $10 bn?
The second part is the excess liquidity with the banks. As all the dollars coming in would be swapped for rupees by banks, theoretically, for every $50 bn coming in, there could be an inflow of Rs 4.8 lakh crore as deposits. While a part would be used for credit, the balance will probably be invested in G-Secs. Here there could be some regulatory action called for from the RBI. This has not been mentioned in the policy, and it is more likely that this issue would crop up in October when the FCNR scheme would have culminated.
Hence, putting all these pieces together, it would appear to be a fairly comfortable liquidity situation for the banking system. The growth in credit has outpaced that in deposits so far, thus creating liquidity issues. This will no longer be a challenge, as there will be a problem of surpluses. It could be that these incremental deposits get channelled to government paper in the absence of lending opportunities.
The forex reserves of the RBI would increase, thus ensuring that the balance of payments is strong in the positive territory. This should help stabilise the rupee. Hence, irrespective of the war and the accompanying uncertainty, the forex market should be in balance.
But with inflation creeping up, a rate hike is very much in order. The bond market has not quite reacted to this as yet but will do so once the repo rate is increased. This also means that for borrowers, the era of low interest rates is over, as rates would only move upwards. It should be noted that the RBI research shows that the real interest rate should be 1.4-1.9%, and with the three quarters into the first of next year averaging 5.5%, the current repo rate is not tenable. Deposit holders, however, may wait for rates to go up, which will get hampered by the fact that the excess FCNR may just obviate the need to raise more deposits.
The author is Chief Economist, Bank of Baroda and author of ‘Corporate Quirks: The Darker Side of the Sun’. Views are personal.
