Saugata Bhattacharya: Repo rate cut likely, but how much will depend on economy

The Reserve of India (RBI) nears a policy decision in a “once in a lifetime” environment. Banks are flooded with liquidity and near term growth is uncertain. Globally, developed countries seem to be transitioning from monetary to fiscal stimuli; capital flows and emerging market currencies have become volatile. 

Analysts have factored in as much as a 0.5 per cent repo rate cut. It is likely that the repo rate will be cut, and indeed desirable, given the expected adverse impact on the breadth, depth and duration of a slowdown, plus a drop in inflation, however, transient. 

However, there are some reasons for caution. In the US, markets have priced in a 100 per cent  probability of a rate hike by the US Fed in mid-December, which will limit market volatility. But, the tone of the  Federal Open Market Committee statement will result in a fresh round of speculation on the extent of rate hikes in 2017, resulting in further moves in exchange rates. 

Metals prices have moved up and are expected to rise further due to fiscal stimuli in the US and other countries; excess capacities in various sectors have come down and inventories progressively depleted. A further weakening of the rupee might amplify a transmission of prices into India. Amidst the “demonetisation” process, inflation is likely to fall over the next couple of months, but the view thereafter remains fuzzy. 

“Financial conditions” have eased significantly in November. First, despite an incremental cash reserve ratio hike, there is still surplus liquidity in banks, with all interest rates — fixed deposits, commercial paper, T-bills and sovereign and corporate debt — lower. Second, over the past couple of months, the rupee has weakened from 66.5 against the US dollar to 68.66. Excess liquidity and a weaker domestic currency is considered de facto expansionary policy.

Policy decisions balance various objectives. One, lower borrowing costs versus lower interest on savings. Reduced savings in the near future will not matter much, given weak credit demand, but a behavioural change might impact eventual credit offtake. Second, if the rupee were to weaken, even if temporarily, given narrowing interest rate differentials 

FPI debt might flow out, generating volatility. FPI debt outflows have been over $2 billion in November alone. 

In summary, RBI will have room for deeper rate cuts than seemed feasible a month back, but the extent will depend on how the economy and fiscal policy evolves over the next few quarters. 

The author is senior vice-president (business and economic research) at Axis Bank