A change of guard at the Reserve Bank of India

It’s time for change in the way that the Reserve Bank of India will set monetary policy and we’ll get a sense of how that’ll pan out starting this Tuesday, 5th of October. Breaking from hallowed tradition, the central bank shall now discuss and set monetary policy measures within the confines of a new Monetary Policy Committee (MPC). The MPC is to comprise 6 members, 3 from the bank and 3 nominees of the government. There is indeed a lot of excitement that this change has brought in its wake. I’ll not be surprised if we have all variety of economists and writers talking about the Hawks and Doves in this MPC. The government nominees are bound to be tracked closely and most of what we shall see in the papers on Wednesday will concern them. I bet there are sources already searching around for psych evaluations and shrink notes. My dream of owning a drone, the size of a fly,  that can sneak in innocuously along with the ‘chai and biscuits’ forming regular fare at the Bank’s meetings is clearly tormenting me. Holy cow! The imagination does run wild these days. Coming back to the point, it’s not easy to figure out the dynamic within a group, especially this one that has no shortage of eminence. But surely, one can expect the group to toe a consistent line in its first session at least. Based on precedent, I think the MPC will reflect a dovish stance and reinforce commitment to an accommodative policy. I’d place my bets on the new RBI governor and chairman of the MPC, Urijit Patel, leading the charge and not bucking the trend. As the American inventor and entrepreneur, Charles.F.Kettering remarked

“People are very open-minded about new things, as long as they’re exactly like the old ones.”

Back in April, when the RBI reduced the benchmark Repo rate by 25 bps (Repo rate is the rate at which individual banks borrow short term from the central bank against government securities), bond markets gave it the cold shoulder. Markets had expected a larger rate cut of 50 bps for one. Cut to the present, the markets would surely want a further rate cut of 25 bps with a further 25 bps in December. The question is “Will RBI appease markets?” Let’s do a quick review of options at hand.

The strongest support for a rate hike in October is the recent windfall from lower Inflation numbers. After 4 successive quarters of rising Inflation, the consumer Inflation number for August turned in a benign 5.05%. As late as July, it stood at over 6%. We’ve had a good monsoon in most parts of the country this year and going by high-frequency food price data, the dip in prices, especially for pulses is significant and sustainable. It’s worth noting that the RBI now follows the Inflation targeting approach. The monetary policy framework between the centre and RBI sets an upper limit of 6% and floor of 2% for consumer Inflation in the period up to 31st March 2021. The data on Inflation should therefore be an encouragement. I agree as well but the MPC will be data dependent. In my view, there’s an 80% probability that the MPC will want future data to be consistent with the recent trend before confidently approving a rate cut purely on inflation data.

Another factor that seems to figure prominently in calls for a rate cut is the disappointing industrial production statistic. Now, the July Index of Industrial Production (IIP) returned a dismal – 2.4 percent (note that IIP for August shall be released in Oct). On paper, that’s a cause for worry. The devil is in the details though and if one were to remove a few antiquated items that form the index, we may well be in positive territory. Here’s a well-articulated piece that identifies reasons for not blindly harping on the IIP (9/10 financial articles that I’ve seen commit the mistake). Now, I’d put my name on the line while stating that MPC members have more reliable data to work with. I’d also like to believe that they’re aware of improved infrastructure and construction sector performance that is likely to buttress the core manufacturing sectors. Yes, private investment has been subdued for a long while now and I’m inclined to believe that a rate cut will not do the trick. One of my earlier blog posts on negative interest rates highlighted the unyielding nature of global private capital formation in the face of ultra-accommodative monetary policy. The problem is that there is still excess capacity and both lenders and borrowers suffer from stressed balance sheets. The same model holds true in India as well.

Finally, there’s going to be an extended discussion on risks posed by a potential rate hike by the US Federal Reserve in December. The Fed held firm in September but the chances of them staying on the sidelines, post elections looks bleak. If the RBI rate cut in December comes close on the heels of the US Fed raising rates, capital outflows will be accentuated and so will volatility. I do not know how the RBI governor will handle this risk. All I know is that faced with such odds, dropping rates now should feel a lot better.

Now, some of the most cited reasons for a rate hike don’t really stack up so strong. Yet, there is merit in using this window to ease policy. My view is that a rate cut tomorrow is a close call. What is easier to forecast is that there is a rate cut coming between now and December. That said, I’m very keen to watch proceedings and glean the committee’s ideas on other matters. I believe we should focus as much on the committee’s guidance with respect to monetary policy transmission and management of liquidity in the banking system. Both are equally important but the latter will be critical in this quarter.

Back in 2013, the Rupee tumbled to its low of 68.85 to the US Dollar in the backdrop of taper tantrum worries. The wobbly exchange rate needed stability and so banks were encouraged to raise foreign currency deposits from their Non-Resident Indian clientele at a fixed interest rate. The RBI, in turn,  promised to shield banks from exchange rate related risks. The Banks thereafter handed over the $26 billion (Rs1.7 trillion) raised via Foreign Currency Non-Resident FCNR (B) deposits, to the RBI via a swap scheme where they continued to receive the Rupee equivalent interest. Now, the RBI has entered into forward purchases through market maker banks to minimize the impact of these outflows upon maturity. However, there are concerns about a US dollar shortage if exporters cancel/roll over the committed dollar delivery. Should such concerns cause a US Dollar mismatch, the RBI might have to draw down its foreign exchange reserves to partly meet redemptions. Thankfully, the reserve chest is sizeable ($ 367 Billion and counting). Irrespective, the FCNR (B) redemptions could temporarily mop up rupee liquidity from the banking system. Since April of this year, the RBI has been narrowing the liquidity deficit through bond buying from banks. Under pressure, the trend could be reversed. The RBI’s guidance on how the process of redemptions can be managed in October – December is something that I hope will reassure markets. Keep watching this space for a future blog post on the subject.



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