Lending rate cut a national priority

We expect the Reserve Bank of India (RBI) to continue to switch to reviving growth on January 29 after exclusively fighting inflation since 2010. After all, India is that rare economy in today’s world in which lending rates are ruling at their 2008 cyclical peak. While growth has bottomed, it is unlikely to bottom out until lending rates soften by another 75 to 100 basis points (bps). In our view, lending rate cuts should be a national priority.

RBI has won the battle against inflation, in our view. A tight money policy should keep core inflation (that is, inflation adjusted for rain, oil and metal shocks) contained at a relatively benign five-six per cent. True, headline inflation will rule much higher, at seven-eight per cent. Although we fancy ourselves uncompromising hawks, we do not see how RBI can possibly counter ‘imported’ inflation from high global liquidity.

In fact, for all the lamentations, India’s inflation, at 150 per cent of growth, is far less acute than Brazil’s 590 per cent or Russia’s 230 per cent. Against this backdrop, we expect RBI to cut policy rates by 25 bps on January 29 and 75 bps by June. It may, then, have to pause till December as inflation will cross 7.5 per cent on the rise in diesel prices every month and power rates. We reckon it will cut by 50 bps in the March 2014 quarter as inflation abates again.

This begs the question: Can RBI rate cuts lead to lending rate cuts? Not if liquidity remains as tight as now.

Although high lending rates are hurting growth, they are not coming down because the $35 billion of RBI forex sales (including forwards) have also pulled down deposit growth. This is why we expect RBI to buy an additional Rs 320 billion of gilts (atop Rs 1,290 billion since April) through open market operations (OMO) or cut the cash reserve ratio by March to improve bank liquidity.

Finally, we expect RBI to address the rising risk from increasingly inadequate forex reserves. Import cover (that is, months of imports fundable by forex reserves) has fallen to six months (adjusted for foreign institutional investor investment in debt), last seen in 1996, from 15 months of five years ago.

In our view, the rupee will not stabilise until RBI begins to recoup the $65 billion (including forwards) sold since end-2008. After all, why will the forex market buy the rupee when the central bank forex purchases are inevitable? As forex reserves turn around, improved investor confidence should support the rupee, a la the late 1990s. This will reduce ‘imported’ inflation, enable RBI to reduce rates further to support growth and attract capital inflows all over again.

(Indranil Sen Gupta is India economist at Bank of America Merrill Lynch)