Blame it on oil

In its February policy, announced a few days after the Union Budget, Indian central bank’s rate-setting body left the repo rate (the rate at which the Reserve Bank of India [RBI] infuses liquidity into the system) and the reverse repo rate (the rate at which it sucks liquidity out) unchanged at 4 per cent and 3.35 per cent, respectively. It also committed to continue with the accommodative stance “as long as necessary to revive and sustain growth on a durable basis”.

The RBI decoupled India’s monetary policy from that of the developed markets. While both the US Federal Reserve and Bank of England have started tightening policy (Bank of England has also raised rates), the RBI took a different stance, based on a benign outlook on inflation, beside supporting and securing growth.

Assuming a normal monsoon, retail inflation is estimated at 4.5 per cent in FY23 — 4.9 per cent in the first quarter, 5 per cent in the second, 4 per cent in the third, and 4.2 per cent in the fourth, “with risks broadly balanced”. The estimate was based on a detailed analysis and extensive homework, factoring in all risks.

But it was done when the crude price was hovering around $90 dollar a barrel. In the past fortnight, it has zoomed to $147.50 a barrel, before coming down to $111.20 in a volatile market.

Can the RBI continue with its accommodative stance and stay away from the rate hike next month? Before looking for an answer to this question, let’s see what’s happening around.

Last Tuesday, the RBI conducted a $5-billion swap auction. When it was announced on February 21, the analyst community was busy speculating on the objective of such a swap. While many believed that the central bank wanted to shrink its balance sheet so that it could transfer more money to the government (for the transfer, the RBI needs to take into account various reserves, risk provisions and risk buffers), others felt the proposed initial public offer of the Life Insurance Corporation of India would bring in tonnes of foreign money and hence such a swap was a prudent move to stall the likely appreciation of the local currency.

Things have changed dramatically since. The rupee touched a new low of 76.97 a dollar on March 7 before rising to 76.595 on March 11. In ten days till March 8, the foreign institutional investors sold equity worth Rs 53,000 crore. India’s foreign exchange reserves, which touched its historic high of $640.4 billion in mid-November 2021, dropped to $631.9 trillion in the first week of March. Indeed, the deprecation in the value of the rupee has to some extent contributed to this but the RBI may also be selling dollars in the market.

The sell-buy $5-billion swap auction attracted $13.56 billion worth of bids; the RBI accepted $5.13 billion for the two-year swap deal. This means, close to Rs 40,000 crore liquidity will be sucked out of the system. For every dollar swapped, an equivalent amount of rupee is drained.

The crude shock can turn into a nightmare for both the government and the RBI. All calculations on growth, inflation, fiscal deficit and current account deficit can go haywire if there is no early end to the Russia-Ukraine war

This money will return after two years but for every dollar sold, the rupee liquidity will be sucked out for good. At this point, no one would complain as the liquidity in the system is around Rs 7.5 trillion. Including the government cash balance, it could be close to Rs 10 trillion. The RBI can afford to sell dollars to protect a sharp erosion in the value of the local currency since it’s sitting on a pile of foreign exchange reserves, the fourth largest in the world.

But that’s only one part of the story. The sudden rise in oil prices is set to spoil the party. The global oil prices averaged $70 a barrel in 2021. The Budget estimates are based on crude prices below $75 a barrel this year. (I am not aware of what the price of crude was on the RBI’s screen when it estimated the inflation trajectory for FY23.)

To use a cliché, we are caught between the devil and the deep blue sea.

If the government decides to absorb the oil shock, there will be pressure on fisc, and the RBI would need to see through the massive government borrowing programme.

The budgeted gross borrowing in FY23 is Rs 14.31 trillion — a historic high. Net of redemption, net borrowing will be Rs 11.186 trillion versus the current year’s Rs 9.348 trillion — again, a historic high. If we add the borrowing of the state governments, the gross borrowings could be in the region of Rs 22.5 trillion in FY23.
 

Despite a very conservative approach on revenue in the Budget, can we meet the estimated 6.4 per cent fiscal deficit in FY23? If the oil price remains high, will the RBI be able to manage the borrowing programme, keeping the 10-year bond yield still below 7 per cent? After rising to 6.96 per cent, it closed at 6.86 per cent last Friday.

Instead of absorbing the rise in oil price, if the government passes it on to the consumers, then inflation will rise. An Axis Bank estimate says every 10 per cent increase in petrol and diesel prices leads to 50-60 basis points (bps) rise in retail inflation: 20-25 bps as direct impact and 30-35 bps as second round. One bps is a hundredth of a percentage point. A March 9 Morgan Stanley report says among Asian economies, India is the most exposed to the upside inflation risks.

Oil is the headline-grabber but all commodity prices are going up. They will feed into the manufacturing sector with a lag effect. So, 4.5 per cent inflation projection for FY23 cannot be achieved. How much it will be is anybody’s guess now. Many believe it will be closer to the upper end of the band and could even touch it in the first half the year. The medium-term target for retail inflation is 4 per cent within a band of +/- 2 per cent.

What should the RBI do in April? Last Friday, RBI deputy governor and member of the Monetary Policy Committee, Michael Patra said the geopolitical developments “may trigger re-calibration of forecasts”. In uncertain times, it can refrain from giving any inflation estimates till clarity emerges. But can it afford to keep its eyes closed on geopolitics? While the accommodative stance can continue for the time being, isn’t the time ripe to raise the reverse repo rate? Let the repo rate remain unchanged at 4 per cent but daily variable reverse repo rate auction can keep the short-term rate at just below 4 per cent in a liquidity flush situation.

If the RBI doesn’t prepare the market for the ground reality, there could be shock ahead.

Its estimate of growth is 7.8 per cent for FY23. An HSBC India report says a 10 per cent increase in crude oil prices will have a 20 bps impact on growth. But a $30 rise in oil prices, from $70 to $100, could impact growth by 90 bps. Going by a recent JPMorgan Chase & Co note, the Brent crude could end the year at $185 a barrel if Russian supply continues to be disrupted. What if that happens?

The writer, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd

His latest book: Pandemonium: The Great Indian Banking Story

To read his previous columns, please log on to  https://bankerstrust.in

Twitter: @TamalBandyo