Repo rate - any choice with MPC for a pause?

Hike in Repo Rate - Is it a case of Hobson's Choice for MPC this time?

Monetary Policy Committee (MPC) meets in Mumbai from 28^th to 30^th  Sep 2022, to review the present monetary conditions and align, if necessary, RBI's policy rate, so as to achieve the committee's mandate of containing inflation within the band of +/-2 per cent over the targeted rate of 4 per cent. Economic experts have already expressed their opinion that the rate hike is imminent again, with guesstimate differing only on the increase in the number of basis points (bps). Shadow committees of the media and few others, are also likely to meet today and tomorrow to give their predictions. As a layman among bankers, I gathered information on some important issues, which formed the core of MPC discussions in the past in arriving at their unanimous/majority decision on policy rates. I share the same along with my views. 

External Factors:

1.     US Federal Reserve Interest Rates (Fed rates): Federal Reserve Interest Rate, the interest rate at which overnight borrowing/lending take place between credit unions/banks in US, has gone up by 75 bps on 21^st September 2021. This is the third consecutive hike of 0.75% since March 2022 and the present fed funds rate ranges between 3-3.25%. During the same period, Reserve Bank of India (RBI) increased its repo rate by 140 bps (from 4.0% to 5.4%).  It is also reported that the gap between US Fed rate and RBI policy rate has come down from 3.85% at the beginning of the year to 2.25% now.

The immediate impact of any rate hike by US is felt in our stock market, as the net return, after factoring in the present value of Indian rupee vis-à-vis US Dollar (USD), in equities/bonds becomes less attractive. As per the monetary report from RBI, portfolio outflows during the current financial year are to the tune of USD 13.3 billion up to July 2022.  Hence the MPC may have to consider the Fed rate hike in their review meeting, in order to minimise the forex outflows.

2.     Current Account Deficit (CAD) : In the fourth quarter of FY 2021-22, the deficit stood at USD 13.4 billion as against USD 8.1 billion in the fourth quarter of the previous year. RBI  Governor, in his last  report, mentioned that due to elevated global commodity prices, the merchandise imports surged to record high and the merchandise trade deficit expanded to USD 100 billion in April- July 2022. There are also reports that the trade deficit expanded further and was at USD 28 billion in April – June 2022. The balooning deficit is bound to have a direct bearing on the forex reserves

3.     Rupee Depreciation: From a level of 1 USD = Rs.74.50 as on 01^st January 2022, the rupee is now trading in the 80-81 range, which means a depreciation of more than 8% against the dollar. A good amount of Forex Reserves are used by RBI to defend and reduce the depreciation impact on rupee. Some give an argument that the rupee should be allowed to find its level without intervention of RBI. Any such move will impact CAD and will  also result in surge of inflation still further.

4.     Forex Reserves: As on 16^th September 2022, the forex reserves held by RBI was USD 545 billion. During the last one year, the reserves had come down by USD 94 billion and since March 2022, the reduction is USD 62 billion.  After the last MPC meeting in August, the forex reserves declined by  nearly USD 20 billion. The current level of Forex Reserves are adequate to cover gross imports of 8-9 months only as against coverage availability of 13-14 months of imports in early 2022.

Domestic Factors:

a.     Inflation: For the 8th month in a row, CPI based inflation is above 6%, the upper band of targeted inflation (4% +/-2%) to be achieved through RBI measures. The average inflation, which was 6.34% in Jan -March quarter, shot up to 7.5% in April-June quarter and is likely to end up at 7.0% during the current quarter. Inflation remained at above 7.0% levels since April 2022, except for a slight dip at 6.7% in July 2022. Higher import prices coupled with depreciation of Indian rupee reduced profit margins as input costs had gone up. Hike in bank lending rates pushed the finance costs up.  Transmission of such added costs gets reflected in selling prices across manufacturing and service sectors, shooting up the inflation still further. Hence, RBI itself admitted that the inflation might come below the target band only in 2022-23. In this situation, containing inflation, naturally, will be the main focus in the ensuing MPC review meeting.

b.     Growth: GDP growth year after year, ever since 1961 (COVID driven 2020-21 being  the lone excepton)* is the single most important factor that is attracting foreign investments, though huge deficit in merchandise trade and consequent current account deficit and depreciation of Indian rupee continue to bother us. (*In the year 2020-21, our GDP was minus 6.6%).  Indications are that our GDP growth for the current FY 2022-23 may be around 7% (RBI projected it at 7.2%), which is much less than 8.3% growth achieved in 2021-22. Even then, the projected GDP growth is much higher than the GDP estimated to be achieved by all other countries, individually. Several positive factors do indicate that the country is poised for a persistent and sustained growth. Capacity Utilisation in the manufacturing sector has improved by more than 600 bps last year and was 75.3% in Q4 2021-22.  Manufacturing PMI (Purchasing Manager’s Index), an indicator of business activity, rose from 53.9 in June to 56.4 in July. The data is on the upward curve for the last one year. Bank credit up to July 22 has grown by 16.2% y-o-y . During the current FY, bank credit has grown by Rs.4.78 lac cr. with retail (Rs.1.89 lac cr), NBFCs (Rs.0.95 lac cr.) and Agri (Rs.0.70 lac cr.) accounting for the major chunk.  Trade and Industries segments have also reported decent growth during the period. Even after the hike in the bank lending rates, credit growth continues to be impressive in the retail and corporate segments. However, any further hike in lending rates may alter the story.

c.      Inflation Target Breach: RBI is given the mandate to meet the inflation target of 4% with a upper and lower band of +2% and -2% respectively. If RBI is unable to meet the inflation target for three consecutive quarters, the regulator has to explain to the government, as to why the target could not be met. As explained in the paragraph relating to inflation, it remained above 6 per cent in the first eight months of the current year and is likely to be around 7 per cent in September. So, RBI may have to explain, why the inflation target could not be met for three consecutive quarters. This is likely to have a bearing on policy rate change discussions by MPC, when they meet from 28^th-30^th September 2022.

Conclusion: 

Three reasons why repo rate will go up. 

A. RBI may be able to reduce FPI outflows, if the policy rate is increased further, though not in matching terms with the FED rates. 

B. To contain inflatiion, RBI always deploy the policy of making the money dearer. 

C. As the RBI owes an explanation for inflation remaining beyond 6% for more than three quarters, the MPC may not be able to call a 'pause’ in policy rate. 

One reason why repo rate should not be hiked.

But continued increase in repo and consequent hike in bank lending rates is likely to make growth stagnant, sooner than later. In that scenario, the of issue of stressed loan assets may also crop up. If the growth is stagnated, India may not be able to attract fresh foreign direct investments, which (along with export income from software services) played a major role in managing our negative balance of payments position for so many years. 

Considering all the above, my view is that MPC may go in for an increase in repo rate of 25-35 bps. (If maintaining growth scores over inflation, the increase may settle at 25 bps; if containing inflation prevails, the increase may be fixed at 35 bps) 

Regards

V. Viswanathan

26th September 2022.