MPC Preview: Wider Budget Gap Sharpens Focus On RBI’s Liquidity Policy
Shaktikanta Das, governor of the Reserve Bank of India (RBI), reacts during a news conference in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

MPC Preview: Wider Budget Gap Sharpens Focus On RBI’s Liquidity Policy

India’s Monetary Policy Committee will meet for the last time this financial year, days after the central government presented its Union Budget for 2021-22. The budget pegged the fiscal deficit at a wider-than-expected 6.8% for the coming financial year, leaving the bond markets concerned about high government borrowings.

As such, while a majority of economists expect no change in interest rates, any indication of the central bank’s plan to normalise liquidity will be closely watched.

Repo Rate: An Outside Chance Of A Cut?

A Bloomberg poll of 32 economists showed that five expect the central bank to cut rates, while 27 anticipate a status quo. The policy repo rate is currently at 4%, while the reverse repo rate is at 3.35%.

An outside chance of a rate cut has opened up after the sharp fall in retail inflation in December to 4.59%, which is seen continuing in January with inflation likely to fall to 4.4%, according to a Bloomberg poll.

“We expect a 25-basis-point cut,” wrote Abhishek Gupta of Bloomberg Economics. “In its December meeting, the MPC broadly agreed that additional policy stimulus was needed to nurture a nascent recovery and that near-term inflationary risks were holding back further rate cuts. Since then, inflation concerns have abated sharply. In addition, the composition of the MPC remains highly dovish,” Gupta wrote.

The policy repo rate was reduced by 115 basis points after the Covid crisis hit in March 2020.

CPI Inflation: Relief At Last

Retail inflation fell sharply in December, led by a crash in vegetable prices.

With the drop, inflation fell back within the MPC’s target range of 4 (+/-2)% for the first time since March 2020. Inflation in December was at its lowest in 15 months, while inflation in food and beverages dropped to 16-month low of 3.87% in December.

This may provide some comfort to the MPC but not everyone believes it will be enough to seal a rate cut call.

“We think the RBI may signal some uncertainty around food prices, since the recent decline has been driven by perishable items, which tend to be more volatile than prices of non-perishable food, which have consistently ticked higher,” said Rahul Bajoria, chief India economist at Barclays. The summer months have historically seen a rise in food prices, which could push up the food index by an average of 5 percentage points over April levels, he said.

Core inflation has been stickier and was at 5.34% in December 2020 compared to 5.56% in November. Metal and fuel prices have risen materially, and are imparting an upside bias to inflation as producers may look to pass on higher costs to consumers in an environment of reviving demand, he said.

Bond Market: Rising Yields

Should the MPC keep rates on hold, as most expect, the focus will be on the RBI’s liquidity policy. Higher-than-anticipated government borrowings of Rs 12 lakh crore in FY22 pushed up the benchmark 10-year bond yield to above 6%.

While the RBI is expected to keep the policy rates unchanged, it is likely to guide for continued accommodative stance, said Kapil Gupta, economist at Edelweiss. The recovery is still nascent and the fiscal push and higher borrowings seen in the budget warrant continued RBI support, he said.

To fund the fiscal deficit, the RBI is expected to hike the ‘held-to-maturity’ limit for banks, which will incentivise them to invest their surplus money market liquidity into government securities, according to a note by BofA Global Research. This, as the high money supply growth will constrain the RBI from large-scale open market operations, the note said.

Given the higher-than-expected fiscal stimulus, the MPC is now expected to be on hold in FY22 and hike rates by 100 basis points in FY23, BofA Global Research said.

Excess Liquidity To Continue

Economists expect that the RBI will allow a significant liquidity surplus to persist for now. Guidance on whether the cash reserve ratio cut of 100 basis points, which expires in March, will be extended is awaited.

Gupta of Edelweiss said the RBI is not expected to rush to withdraw liquidity. “We will keenly watch the RBI’s commentary or guidance on further normalisation of the liquidity management framework and, more generally, liquidity conditions,” he said.

The central bank could be looking to possibly do the ground work to communicate a gentle normalisation process, but one which would err on the side of caution and growth, said Bajoria. “As such, we expect the RBI to reassure markets about ample liquidity.”

Comfort On Growth

While noting the fall in inflation and tip-toeing through its stance on liquidity, the central bank and the MPC will likely signal growing comfort on growth.

In December, the RBI had projected real GDP to grow 0.1% in the October-December 2020 quarter, and by 0.7% in the January-March 2021 quarter. Since then, high-frequency indicators have held up well.

“While inflation is easing and growth improves in the near term, it is unclear which direction we will swing thereafter,” said Bajoria. While things are looking good for now, the impact of the pandemic on income and, by extension, on growth will remain a question, he said.

Our conviction is that the RBI will struggle to raise rates with conviction early next year. A case may be made for normalisation if growth is much stronger the next year as well.
Rahul Bajoria, Chief India Economist, Barclays 
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