RBI monetary policy: Pause now, cut in December

We expect the Reserve Bank of India’s  Monetary Policy Committee to pause on Wednesday and cut rates by 25 basis points (bp) on December 6, to signal bank lending rate cut, before the ‘busy’ October-March industrial season intensifies. We see six compelling reasons for easing. 

First, growth at 5.5 per cent, as per the old GDP series, even factoring in a bounce on demonetisation shock-led base effects, is well below our estimated 7 per cent potential. Second, the CPI inflation is likely to normalise to around 4.5 per cent in the first half of FY18, well within the RBI’s 2-6 per cent mandate. Tomato and onion price inflation is subsiding with resumption of domestic supply as well as imports. 

Third, the RBI MPC will likely ignore the statistical increase in inflation due to a hike in house rent allowances by the Seventh Pay Commission. Fourth, the differential between the Fed's and the RBI's policy rates would remain a healthy 450 bp, even after a December Federal Open Market Committee (FOMC) hike. 

Fifth, we expect the government to fund fiscal slippage by expanding foreign portfolio investment’s G-sec limits. Finally, we fully share RBI Governor Urjit Patel's concerns about farm loan waivers, but think that is a separate dialogue that the RBI must hold with the political stakeholders. 

How much further could the RBI cut? We would not be concerned if the real policy rate were to run at a negative 50bp, taking medium-term 6.5 per cent CPI inflation as a proxy for inflation expectations. 

We note that former RBI governor Bimal Jalan had similarly gone down to a 50-bp negative real rate in the early 2000s. Far from stoking inflation, this had put India at the head of a global recovery. As the first 50-bp cut in the March 2015 quarter did not transmit to bank lending rates due to tight liquidity, the RBI MPC will likely need to compensate with another cut, especially before the ‘busy’ season. 

We expect Patel to make a strong case for lending rate cuts. We believe lending rate cuts hold the key to a cyclical recovery. We have never shared the market's enthusiasm for reforms (which can take 5-10 years to show up in growth numbers) or the restarting of stalled projects (given idle capacity). Lending rate cuts would revive demand, put idle factories to work, exhaust over-capacity and boost investmentin two-three years’ time. A recovery would also improve bank-asset quality as the bulk of non performing assets (NPAs) are cyclical.

In sum, we think the stars are aligning for banks to cut lending rates. Reserve money growth is normalising (10.2 per cent since April) on RBI FX intervention: Rs 1 of reserve money generates Rs 5.15 of loan supply. Second, we estimate that the demonetisation shock has generated permanent bank deposits of Rs 4 trillion (25 per cent of demonetised notes). Banks should gradually extend loans from the Rs 1.5 trillion in cash management bills and MSS bonds. Finally, lower risk free (10 year) rates — down 50-75bp since April 2016 — are also creating scope for lending rate cuts. 

The writer is co-head and economist, India Research, Bank of America Merrill Lynch.

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