RBI's pause not without reason

The Reserve Bank of India (RBI) does its reviews on the first Tuesday of every alternate month. The US Federal Open Markets Committee (FOMC) does policy reviews in mid-month. When the months coincide, RBI is usually conservative because it waits for the Fed's action. This time around, RBI also has to consider the Brexit referendum on June 23, which might, one way or another, affect currency markets. If Britain does opt to leave the European Union (EU), there will be massive turmoil in forex markets. The euro and the pound will be hit hard. On the other hand, if Britain votes to stay in the EU, there will probably be a strong relief rally in euro and pound.

So, it's not surprising RBI has decided to stand pat. Growth in India seems to be well on course, albeit still somewhat patchy, going by the latest GDP numbers and by corporate results. Inflation is somewhat higher than comfortable. So there is no reason to cut rates.

It is even possible RBI may have to take action out of turn and raise rates in end-June if the UK does pull out of the EU, and the FOMC decides to hike rates. In such scenarios, there would be excessive volatility across forex markets and the rupee might require monetary defence. In many ways, the central bank has its task cut out in six months. Inflation targeting in itself will be a tough job since inflation is moving up. A good monsoon will be necessary but may not be sufficient to control price rises.

The CPI for April was up 5.4 per cent year-on-year (y-o-y). The WPI moved out of negative territory in April and rose, admittedly by a tiny 0.34 per cent y-o-y, for the same month. This is the first time in 18 months that the WPI was in positive territory. In both cases, the big gainer was food but fuel is also up and even core inflation stripped of food and fuel may be headed up. The next informal but oft-mentioned inflation target is four per cent on the CPI by March 2017. Monetary policy is not the ideal tool for managing either food or fuel inflation. If food and fuel continue to trend up, RBI can do little except keep interest rates high.

Starting September, RBI will also have to unwind $34 billion worth of swaps. Those swaps were taken between September and December 2013 when the rupee came under major pressure. Coincidentally, September 2013 was also when Rajan took charge. Picking up that $34 billion warchest gave RBI ample ammunition to intervene as required. Unwinding those positions without setting off excessive volatility will be a delicate task, especially if the Fed is hiking dollar rates in the second half of calendar 2016.

That $34 billion is a little less than 10 per cent of India's current reserves. The exact breakup of positions and the averaged exchange rates in the swaps is undisclosed. So, we don't know how much was gained or lost when RBI offered concessional terms to member banks. Nor do we know the comfort levels for unwinding.

The real dilemma is that at one level, India's exports are near-collapse and a weaker rupee could help. On the other hand, a weaker rupee means higher inflation. It will be interesting to see how Dr Rajan, or his successor, balances these two opposed imperatives.
The author is a technical and equity analyst