RBI MPC Meet: This Time Is (Slightly) Different, For India

The Monetary Policy Committee faces a dilemma. As a flexible inflation-targeting central bank, the committee should respond to the inflationary consequences of rupee depreciation, rather than hike rates to defend the currency. But even as inflation is set to undershoot its previously projected path in coming quarters, currency weakness and rising oil prices have led to the expectation of a rate hike; not only at the October policy meeting, but also beyond that. Is that a reasonable expectation? The answer depends on two factors: a cost-benefit analysis of rate hikes to defend the currency and a reassessment of inflation, incorporating supply (rupee, oil) and demand (growth) shocks.

A Cost-Benefit Analysis

Let’s assess the cost-benefits first. Rate hikes to defend the rupee from a financial stability standpoint are not a novel idea. This year alone, emerging market economies from Argentina, Turkey, to Indonesia have hiked rates to defend their currencies. In July 2013, India had also announced a steep hike in the Marginal Standing Facility rate to stem currency volatility. However, the evidence on the success of defending a currency is mixed at best.

This should not be surprising as capital flows are driven by factors other than interest rate arbitrage. Portfolio flows (both debt and equity) and loans (external commercial borrowings and trade credit) are driven more by global push factors such as global financial conditions rather than domestic-pull factors.

For countries that receive large dollar-denominated inflows, financial stability is important. But foreign holdings of debt securities (government and corporate) as a percentage of outstanding are only 4.2 percent in India, much lower than in Indonesia (37.6 percent). Given India’s relatively closed capital account, particularly on debt, capital inflows – both debt and equity – tend to be more growth sensitive. Hence, policy tightening that results in a significantly weaker growth outlook can also backfire by triggering outflows of growth-sensitive capital.

An interest rate defence works when it is seen as credible.

It is also important to recognise that India’s macro fundamentals are in a much better shape today, compared with 2012-13.

• CPI inflation has moderated (to about 4.5 percent in 2018 from 9.7 percent in 2012), as has the current account deficit (about 2.5 percent of GDP versus 5 percent).
• Real rates are positive (+2 percentage points versus -2 percentage points).
• The Reserve Bank of India has a sufficient foreign exchange reserve buffer (9.3 months of import cover versus 6.4).

Hence, a panic reaction is not warranted.

Re-Visiting The Inflation Outlook

But what about the risks to inflation due to recent supply shocks (higher oil prices and a weaker rupee) especially given very strong growth recently? It is true that India has witnessed an inflationary recovery since end-2017. Headline GDP growth of 8.2 percent year-on-year, during April-June 2018 is impressive, but the question is whether this will be sustained.

We are growing increasingly concerned about the sustainability of this growth cycle. Capital outflows have tightened external financing conditions. The gradual tightening of banking system liquidity and higher money market rates since late last year has already tightened domestic financial conditions at the margin. And now with even higher costs of capital for the non-banking finance companies, the flow of financial resources from the non-banking sources is also likely to shrink. This suggests that growth capital – via both domestic and external sources – will be limited, which in turn will slow consumption and investment demand. Add to that the adverse impact of rising oil prices on households’ real disposable incomes and on profit margins of companies.

The central government has spent around 44 percent of its budgeted target for capital expenditure in the first five months of 2018-19 versus 35.5 percent during the corresponding period last year.

Given likely disappointment on goods and services tax collections, the only route to attaining the 3.3 percent of GDP fiscal deficit target in 2018-19 will be to prune spending, which implies a negative growth impulse from the central government in the second half of 2018-19. If global growth also slows in coming quarters, as we expect, then it is clear that a cocktail of factors are already in place for domestic growth to moderate.

Despite the upside risk to inflation from higher oil prices and a weaker rupee, the continued downward surprise in food price inflation and our expectation of a growth slowdown suggest the central bank’s forecast of CPI inflation of 4.8 percent during H2 2018-19 will be undershoot by around 50 basis points.

Core inflation looks elevated on a year-on-year basis due to base effects, but its momentum has also stabilised. The seasonally adjusted “super core” index (CPI excluding food & beverages, fuel, petrol, diesel and housing rent) rose by an average of 0.24 percent month-on-month during June-August, down sharply from 0.44 percent over the previous 12 months.

We also measure underlying inflation via the 10-percent trimmed mean, which excludes the 10 percent of the highest and lowest inflation categories. The trimmed mean moderated to 4.3 percent year-on-year in August from this year’s peak of 4.7 percent in May.

For a forward-looking monetary policy committee, which has headline inflation as its primary mandate, this undershoot should be a material input into its decision-making process, especially as the lagged effect of past monetary policy tightening and various growth headwinds is yet to be reflected in inflation.

Anchor The Anchor

To conclude, if costs of a currency defence exceed its benefits, and if headline inflation is well behaved, then there is a much weaker case for the Reserve Bank of India to mimic what other emerging market central banks are doing.

The last four years have taken a lot of hard work trying to anchor monetary policy around headline inflation. The current stress in the currency markets should not un-anchor the anchor.

Sonal Varma is Managing Director and Chief India Economist at Nomura.

The views expressed here are those of the author’s and do not necessarily represent the views of Bloomberg Quint or its editorial team.