Rate hike: A positive communication

The current rate hike appears to be on the back of vulnerability in the external sector

The Reserve Bank of India decision to raise repo rates was perhaps dictated by a desire to move ahead of the curve and hence impart credibility to the inflation targeting framework. The unanimous rate hike call by Monetary Policy Committee members is also a smart communication to the markets of speaking in unison. This is perhaps to negate the market cacophony of interpreting diverging views in minutes and policy press statements as happened in April. As AS Blinder said, “A central bank that speaks with a cacophony of voices may, in effect, have no voice at all.” The other good thing is that the RBI has kept the policy stance in neutral mode indicating the desire to be pragmatic as inflation numbers in H2FY19 are going to trend lower. 

Interestingly, the RBI said in the policy that the “increase in growth has been underpinned by a significant upward revision in private final consumption expenditure (PFCE)". The RBI explanation of improved rural demand may however be a statistical artefact as the PFCE growth has, in fact, decelerated on a year-on-year basis from 7.3 per cent to 6.6 per cent, though compared to second advanced estimates PFCE grew by 50 bps more to 6.6 per cent (previously 6.1 per cent). Further, on a quarterly basis, PFCE has expanded by 6.7 per cent over a weak base. In fact, on an unchanged base, PFCE has decelerated to 4.5 per cent in Q4FY18, the lowest since Q4FY17. Clearly, the narrative on PFCE may be euphoric and too early to celebrate. 

The good thing is that nominal non-agri GVA has expanded from 11.5 per cent in Q4 FY17 to 12.0 per cent in Q4 FY18. During the same period, nominal agri GVA declined from 10.9 per cent to 4.9 per cent. Real manufacturing growth (8.8 per cent in Q4FY18, the highest since Q1FY17) and the Index of Industrial Production (both show real growth) are moving in tandem, suggesting the effects of cascading supply shocks (the Benami Act, demonetisation, GST, RERA) are now mostly over.

Clearly, India is growing, but Bharat needs to keep pace. In this context, an income/price compensation for farmers is necessary to lift rural consumption and make growth more broadbased. We believe, given that market prices are currently higher than MSP, an income compensation scheme may not have any material impact on inflation, though it could add to fiscal costs (could be negated though with growth trending higher). However, it is imperative to support the rural sector as it could quickly result in an all-round feel good factor in an election year.

Our estimates show that the system is expected to have a net liquidity deficit of Rs 1.1 tn in FY19. Hence, RBI should do open market operations purchase/permanent liquidity injection of at least Rs 1 tn this fiscal. Otherwise, the trend of marginal cost of funds-based lending rate (MCLR) increases getting divorced from repo rate increases looks imminent. 

On the developmental front, numerous measures have been announced. For example, the convergence of priority sector lending (PSL) guidelines for housing loans with the affordable housing scheme is a welcome step and may help banks meet the PSL targets. Consequently, the same amount of money will be released from Rural Infrastructure Development Fund (RIDF) and banks may invest the same with a higher return.

Many banks are finding it difficult to achieve their liquidity coverage ratio (LCR) target of 100 per cent by January 1, 2019. To ease the pressure, the RBI has given additional relaxation of 2 per cent under the facility to avail liquidity for liquidity coverage ratio (FALLCR). The total carve-out from statutory liquidity ratio (SLR) available to banks would be 13 per cent of their net demand and time liabilities or NDTL. This is expected to impact Indian banking system positively as it will release addition funds from high quality liquid assets   requirement and improve the LCR position. However, this may lead to a negative incremental demand for bonds. 

In line with the government’s focus, the RBI has also given a boost to the MSME sector in terms of asset classification. It has given time to adjust the mark-to-market losses in Q4FY18 to adjust in the next four quarters. This has now been extended for Q1FY19 to adjust the losses in another four quarters. 

In hindsight, the current rate hike appears to be justified on the back of vulnerability on the external sector. At six months import cover and available data on external debt, the reserves are just sufficient to cover transactions, precautionary and speculative motives leaving little room for geopolitical and other risks. Overall, we believe this rate hike could still turn out to be a shallow cycle.

The author is group chief economic advisor, State Bank of India. Views are personal