RBI: Liquidity, liquidity, liquidity

Reserve Bank of India (RBI) Governor Raghuram Rajan is expected to cut rates by 25 basis points (bps) on Tuesday, and again in August. The RBI should also reiterate its 'accommodative' monetary policy stance. With the slack season setting in, banks could follow with a 25 bps lending rate cut adjusted for changes in the methodology. At the same time, we cannot over-emphasise the need to provide sufficient liquidity to pull down lending rates to spur recovery. In fact, there is a strong case for an open market operations (OMOs) calendar, especially if portfolio flows remain volatile with emerging markets coming into question as an asset class.

The onus of recovery is now really on the RBI. Finance Minister Arun Jaitley has stuck to the pre-committed fiscal deficit target of 3.5 per cent of gross domestic product, or GDP (and cut small savings rates). After all, 20-year high real lending rates continue to constrain growth. Not only has old GDP series growth dipped to 4.6 per cent in the December quarter, but also the industrial production has contracted for three months through January.

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Lending rate cuts hold the key to recovery with growth running at, say, 200 bps below the potential. Why would any firm invest when it has idle capacity? Lending rate cuts will spur demand, complementing the consumption stimulus of, say, 0.5 per cent of GDP from the 7th Pay Commission for the next three years. This will exhaust capacity, sparking off the investments. To expect capex revival before rate cuts is to put the cart before the horse!

Risks to the RBI's five per cent FY17 consumer price index (CPI) inflation forecast are surely beyond the ambit of the monetary policy. First, the Southern Oscillation Index is still hovering around El Niño mode, putting a question mark on the monsoon. This could sustain agflation, with poor rains already drying up rivers. Second, a rebound in oil prices from low sub-$40/barrel levels could mathematically push up inflation, especially with a still-strong US dollar weakening the Indian rupee. A five per cent hike in domestic petrol and diesel prices raises CPI inflation by 40 bps over time. Finally, the 137 per cent hike in house rent allowances by the 7th Pay Commission could also push up rental and CPI inflation, notionally.

One cannot over-emphasise the need to provide sufficient liquidity to pull down lending rates. With portfolio flows stalling on uncertainties about Fed hikes, there has been a continuous need for RBI OMO since mid-2015. The BSE Sensex one-year forward price-earnings ratio is also trading at a relatively rich 16x. The RBI has finally provided two-thirds of our estimated $30 billion permanent liquidity requirement as estimated. This will keep the money market deficit at a relatively high Rs 80,000-1,00,000 crore in April-May, if portfolio flows do not return meaningfully. Against this backdrop, there is a strong case for an OMO calendar, as portfolio flows will swing on Fed hike uncertainties.

In fact, there is a possibility that the RBI may have to step up OMO to Rs 1,80,000 crore in FY17 from Rs 1,23,500 crore (including government buybacks) in FY16, assuming that half of the FCNR deposits of $26 billion are withdrawn on maturity in September. Although the RBI has contracted forwards of $28 billion, banks will still need to retain nostro FX balances of $10-15 billion for the day-to-day transactions.
The author is co-head & economist, India Research, at Bank of America-Merrill Lynch. Views are personal