The macroeconomic indicators are all blinking red. Inflation doesn’t seem anywhere near the Reserve Bank of India’s (RBI) comfort level, growth has plummeted and the Union Budget’s fiscal consolidation plan has under-priced subsidies again. None of these factors seems to suggest a rate cut is imminent. Additionally, RBI’s intervention in the foreign exchange market to support the rupee has resulted in a severe liquidity crunch, as reserve money creation has been slow. Indranil Sengupta, economist at the Bank of America Merrill Lynch, says forex intervention has contracted M3 (money supply) growth to a by-far-too-tight 13 per cent, as high lending rates have pulled growth down to 6-6.5 per cent.
Tight liquidity conditions have resulted in yields on sovereign paper shooting up. All these conditions don’t seem to suggest RBI is going to cut rates meaningfully anytime soon, even as the markets have been factoring it in for a while. Going by recent developments, strategists believe the central bank will step in and buy government securities tactically to comfort the sentiment when the 10-year gilt goes past 8.5 per cent. The clamour to cut rates has almost reached a fever pitch now, as it’s apparent that RBI’s massive tightening has only hurt growth and failed to tackle “imported inflation”.
If growth has to revive, M3 must increase. Some economists believe RBI will have to work towards this, as tight monetary policy conditions have pulled M3 growth to 13 per cent in March from 16.3 per cent in September. When M3 crosses the 20 per cent mark, the risk of inflation becomes real. If the economy has to grow at 7.5-8 per cent, M3 has to grow 17 per cent, explain economists. If it falls below this and lending rates stay high, growth would be choked. Many economists have been citing the example of 1997, when excessive tightening resulted in growth choking. However, it seems unlikely this time, as, unlike then, RBI has many levers to support growth.
The 125-bps cut in the Cash Reserve Ratio (CRR), coupled with open market operations worth Rs 1,20,000 crore, will push M3 growth back to 17 per cent. The market expects RBI to cut CRR by another 50 bps in October and interest rates by 50-75 bps between April and July. Edelweiss Securities believes that in the next couple of months, due to redemptions and government spending, the liquidity adjustment facility deficit is expected to taper. Borrowing by companies and individuals, at a low right now, needs to pick up. This will only happen once RBI cuts rates. When it does that, we should see an uptick in growth.
