A lot has changed between the last meeting of the Monetary Policy Committee (MPC) on December 8 to now, developments that will weigh heavy on the minds of the six members as they deliberate on the future course of the monetary policy.
From omicron to inflation, there are several macroeconomic challenges before the Reserve Bank’s MPC. The biggest challenge of all is the unexpectedly large government borrowing programme, where seven out of 10 economists that CNBC-TV18 polled cited this as the key factor that may complicate matters for RBI perhaps even result in a recalibration of the speed of policy withdrawal.
Set Up for Policy
Seventy percent of the respondents polled by CNBC-TV18 cited the central government’s unexpectedly large borrowing program as the biggest challenge for the central bank, as it may influence the pace of liquidity normalisation. The poll was conducted across ten economists from India’s largest banks and brokerages.
In FY23, the total central government market borrowing through dated securities has been budgeted at Rs 14.95 lakh crores, or about Rs 14.3 lakh crores after factoring in the switch of certain papers to a later date. This was far higher than what the markets had pencilled in, at about Rs 12 lakh crores at best.
Add to this borrowings from states and other public enterprises, and the total public borrowing could be as high as Rs 19.9 lakh crores as per State Bank of India’s estimates. There is also been no clarity on when the global bond index inclusion may happen. This has made the bond markets jittery, with the 10 year paper rising to a two and a half year high after the borrowing announcement. This would have resulted in a higher borrowing cost for the government. However, on Tuesday there was some respite after the government cancelled the auction of almost Rs 24,000 crores of securities, causing the 10-year benchmark bond yield to fall to 6.80 percent from Monday’s close of 6.87 percent.
To bring down liquidity surplus, and start to withdraw the excesses of the past two years, RBI would have to sell government bonds, which would drive down their prices, and hence push up yields.
How the central bank manages this large borrowing, keeps adequate liquidity to finance the large government borrowing, while also not letting the bond yields rise too much to keep borrowing costs low for the government, is going to be a tough task.
“Recent sharp rise in bond yields may already have tightened the local financial conditions a bit too hastily for RBI’s comfort. We, therefore, expect MPC to embark on a gradual tightening cycle… With policy normalization underway, RBI’s support to bond markets is expected to remain constrained going forward even as headline inflation remains within the RBI’s target band. Tough as it may be, RBI will have to non-disruptively juggle between its objectives on policy normalization and management of government’s borrowing program in FY23,” said Churchil Bhatt, EVP Debt Investments, Kotak Mahindra Life Insurance Company Limited.
Inflation, the central bank’s primary mandate, is seen as the other key challenge, according to twenty percent of the respondents to the poll. RBI’s mandate is to keep consumer inflation near the 4 percent mark, with a 2 percent headroom on either side, ie 2 to 6 percent range. The last reading showed consume price inflation at 5.6 percent in December, significantly higher than the previous month.
“RBI in its last policy had kept inflation forecast for FY22 at 5.3 percent. Currently on a FYTD basis, inflation is at 5.2 percent which is marginally lower than RBI’s forecast for entire year. It is important to note the significant uptick in inflation from 4.9 percent in Nov’21 to 5.6 percent in Dec’21. In addition, rising crude oil prices (hovering near the USD 85-90 mark) remains a cause of concern and will feed into higher inflation. We expect inflation to continue it upwards trajectory and accelerate by 5-5.5 percent in FY22,” Bank of Baroda said in its recent research paper.
The other challenge to reckon with is the imminent hike is interest rates by the US Federal Reserve. Most analysts are expecting a rate hike by the US Fed in March itself, the first such hike since 2018. While this is not a big surprise, and markets have largely factored in a reversal in the Fed’s stance, what could matter is the pace and intensity of these rate hikes.
Why should it matter to RBI?
Theoretically, a rate hike signal in the large developed economies like USA is negative for emerging market economies like India. When the Fed raises rates, the rate differential between US and other EMEs like India rises, making India that much less attractive for foreign investors. So there may be a risk of significant foreign capital outflows from India and into the US. This could also impact the currency value.
Global central banks have already begun hardening their monetary stance with the record-high surge in inflation. The Bank of England has already raised rates. If RBI does not raise rates as well, it will be seen as behind the curve.
Add to these complications are the other worries about the potential impact of Omicron on growth. The good news is that the number of infections are already on the wane, so the impact, if any, would be limited. As per the latest Economic Survey, the Indian economy is estimated to grow by 9.2 percent in real terms in FY22 subsequent to a contraction of 7.3 percent in FY21. GDP projected to grow by 8- 8.5 percent in real terms in FY23.
While the MPC can only tinker with the repo rate, RBI will have to make a decision about reverse repo, and its liquidity stance. With this in mind, what will RBI do
What Will RBI Do?
A poll across ten economists from India’s largest banks and brokerages shows that a majority is expecting the Reserve Bank of India (RBI) to hike the reverse repo rate or the rate at which banks lend money to it, in February 10. The hike is expected to signal the start of normalization and the future trajectory of rates.
Umesh Revankar, Vice Chairman & MD, Shriram Transport Finance said, “Given that on one hand uncertainty around the Covid variants continue and growth is still uneven, inflationary expectations remain high and globally central banks are withdrawing easy monetary policy, against this backdrop, we expect the RBI to continue its path of policy normalization but, rather slowly. As food inflation is likely to be benign, we expect the RBI to hike reverse repo rate first and then may be towards the second half of 2022 there could be a hike in the repo rate as well.”
That said, a third of the respondents are expecting a status quo on reverse repo. The others are expecting a hike of anywhere between 15 to 40 basis points (one basis point is one hundredth of a percent).
“Given that the overnight call rate is closer to 4 per cent, we expect the RBI to change the reverse repo rate by up to 25 bps or make repo the operative rate. While a repo rate hike is not expected, it is possible that the MPC might change its stance to neutral from accommodative,” Shanti Ekambaram, Group President, Consumer Banking, Kotak Mahindra Bank said.
While 70 percent expect the reverse repo hike in February, the remaining were divided on the hike coming either in April, June or even outside the MPC meet. “We believe the time is now appropriate to go for a 20 bps hike on reverse repo rate, but outside the MPC meeting as enshrined in the RBI act that clearly lays down that reverse repo is more of a liquidity management. A hike in reverse repo is also required as a larger corridor has resulted in rate volatility,” said Soumyakanti Ghosh, Chief Economist at SBI.
The repo rate, or the rate at which RBI lends to banks, is only expected to be hiked by June, as per half the respondents. Thirty percent expect the first repo rate hike in August and twenty percent in April.
The RBI is widely expected to leave the monetary policy stance unchanged, at least in the February policy. The Monetary Policy Committee has remained in an “accommodative” stance since June of 2019.
Accommodative monetary policy is when central banks expand the money supply to boost the economy, meaning they are willing to either lower rates or keep them unchanged, but not hike. Since the start of the pandemic, it is estimated that RBI has announced liquidity augmenting measures worth Rs 17.2 lakh crores, or 8.7 per cent of the nominal GDP of FY21.
Any comments on liquidity and the path of normalization will be keenly watched by markets. “We think RBI will extend the enhanced HTM dispensation (limit increased to 22 percent, from 19.5percent) by one more year, to include securities to be acquired between April 2022 to March 2023, with the limits to be restored to 19.5 percent, from 22.0 percent, in a phased manner starting from the quarter ending June 2024,” said Kaushik Das, Director & Chief Economist – India and South Asia at Deutsche Bank.
Among other non-policy measures, market participants will watch out for any comments on the proposed launch of the central bank digital currency (CBDC), the inclusion of startup funding, others in priority sector lending, and RBI’s comments on the progress made on bond index inclusion.
Eight out of ten respondents said RBI will maintain its CPI inflation forecast of 5.3 percent, while the remaining expect it to be hiked to 5.4-5.75 percent. For Q1 and Q2 of FY23, seventy percent of respondents expect the inflation target of 5 percent to also be left unchanged.
Growth projections, however, are likely to be revised down, in line with the National Statistical Office’s (NSO) estimates. Ninety percent of respondents said that GDP growth for FY22 would be revised down from 9.5 percent to anywhere in the range of 9-9.4 percent.
RBI stands at a crucial juncture. The fiscal policy is in expansionary mode, with a large ramp-up in capital expenditure on the cards. Growth is finally back to pre-pandemic levels. Higher inflation is a real risk with the global commodity price rises. Central banks in the largest economies have started raising rates or indicated a hike.
In this scenario, can RBI continue to justify an ultra-loose monetary policy? How much longer can it ignore the higher than comfortable inflation? The central bank knows to sit has to walk a tight-rope.
Watch the accompanying video of CNBC-TV18’s Ritu Singh for more details.