Monetary policy: Risks turning into reality, should the RBI hike?

Since the RBI’s April monetary policy, risks have started – oil prices are up 11 per cent, US yields have been closer to 3 per cent and the US dollar index is up 4 per cent. A combination of higher US yields and US dollar is never a good combination for emerging markets (EMs) and add to that the spectre of rising oil prices – the risks are alive for India. Indeed, foreign institutional investors (FIIs) have pulled out roughly $6.6 billion since April and the rupee has depreciated the most in the Asia ex-Japan (AXJ) region. 

These headwinds expose the fragility of EM external balance sheets and we saw the Bank Indonesia responding with a rate hike earlier in the month, for the first time in four years.  

External headwinds have been the primary reason for analysts to bring forward expectations of a rate hike from the RBI, with a pre-emptive move likely to help preserve macro stability. To add to the external headwinds, domestic factors too have clouded the inflation outlook with core inflation remaining sticky and in the most recent reading inching towards the six per cent-mark, challenges on the fiscal consolidation front and upside risks from minimum support price policy for farm products.

While Monetary Policy Committee (MPC) members will meet in June (June 4-6) against a more challenging macro backdrop, the balance of risks remains skewed to the upside. 

We believe that rate hikes cannot be wished away. We expect that the RBI would likely to keep policy rates unchanged in the June meeting and indicate a change in policy stance for withdrawal of accommodation. While we do expect two votes for the withdrawal as indicated in the April meeting, we do not see a majority of members voting for a hike yet. 

The key reasons we believe that the RBI will defer the rate hike to the August meeting are (1) while the external balance sheet is weak, the key metrics such as import cover (currently at 10.9 months, expected around 8.8x in Mar 19e), external debt at 20 per cent of GDP are not in danger zone, which coupled with the recent retreat in oil prices (more clarity on oil price trend will emerge post the OPEC meeting on June 22) and cooling off in US yields will provide leeway to the central bank and (2) RBI will likely await for more clarity on domestic factors such as details of MSP policy, performance of monsoon and additional data points on inflation and growth trajectory before it embarks on a rate hike cycle. 

More than the change in policy rates, key will be tone of the policy statement and what can be inferred about the quantum of rate hikes. Currently we expect the RBI to hike rates twice in 2H18 as macro stability indicators widen from the lows of last year. However, watch out for the trend in US dollar index, US yields and oil prices which will be key in determining both the timing and quantum of the rate hike cycle in our view.

Upasana Chachra is Chief India Economist at Macquarie