Opinion 2015 cut foretold: 200 basis points

Most forecasts of repo rate cuts needed in India this year seem to be out of sync with the underlying trend of inflation and growth in India and the world.

Surjit S Bhalla

January 23, 2015 09:49 AM IST First published on: Jan 23, 2015 at 12:34 AM IST

RBI Governor Raghuram Rajan set a new goalpost for the tracking of monetary policy in India.

The RBI, over the last several years, has changed the goalposts of monetary policy more often than the batting collapses of the Indian cricket team. Remember protein inflation as a cause of high CPI inflation in India? Or the stubborn refusal of the RBI and its research experts to acknowledge the role played by minimum support prices (MSP) in generating high food and overall inflation in India? In four articles on inflation by the RBI’s executive director and economist Deepak Mohanty, none contains any documentation or discussion of causal linkage on the (now) widely accepted contribution of MSP to inflation. Deputy governor Urjit Patel’s voluminous report on the need for a new monetary framework (that is, inflation-targeting) also does not mention MSP as a cause, but it does discuss the important (sic) role played by the MGNREGA in generating wage and, therefore, overall inflation.

For the last year and a half, we have been fed the mantra of high inflation expectations, low base effect and the prospect of inflation-targeting as possible determinants of theoretical CPI inflation. Coincident with this discussion, actual CPI inflation has halved from the “low base” December 2013 figure of 9.9 per cent to 5 per cent in December 2014. Given this reality, the RBI cut the repo rate to 7.75 per cent on January 15. Given the long wait for this cut, expectations are high, and varied, about the magnitude of repo rate cuts expected in 2015. All economic experts expect at least one more rate cut of 25 basis points (bp), and some even an additional 75 bp. The central tendency of experts’ recommendation is for an additional 50 bp.

Anticipating the conclusion of my research and reasoning (documented here), I believe the additional repo rate cuts needed, and hopefully delivered, are more than thrice those anticipated by the experts.

How is this result derived? By following the RBI logic to its inevitable end. In an interview with Prannoy Roy, NDTV, December 27, 2014, RBI Governor Raghuram Rajan set a new goalpost for the tracking of monetary policy in India. In answer to Roy’s question: “Isn’t it [the case] that real interest rates are too high?”, Rajan responded, “Depends on how you measure real interest rates. The CPI today is about 6-6.5… the real interest rate is 1.5 per cent… It’s about what it is in the rest of the world — it is not higher than the rest of the world — this is where the world is.”

This goalpost of real rates in India comparable to the rest of the world seems eminently sensible in this globalised, hyper-competitive world. And the goalpost does not suffer from the woolliness of inflation expectations, nor from the ambiguity of inflation-targeting. This new metric says that whatever model of inflation one or the RBI or market experts might have, we are expected to be guided by what the central banks in the rest of the world are doing. India is not unique, no matter how much Hindutva experts might claim it is. Red blood also flows through our veins, and if government policy is not interventionist, then Indian inflation is likely to follow the path of world inflation, particularly the path of inflation in emerging economies.

The table documents the average inflation, overnight interest rate (repo) and real interest rate for different classifications of countries in the world. These classifications are: first, 125 countries in the different regions of the world; and second, 39 “representative” economies in the world as reported by The Economist in its table, “Economic and Financial Indicators”. The following three conclusions emerge from this large sample of countries.

First, the 31 countries of sub-Saharan Africa and five countries of South Asia are in a class by themselves in terms of the real repo rate. Both regions report real repo rates in the neighbourhood of 2.8 per cent (the Indian real rate, after the repo cut, is 2.75 per cent, with inflation at 5 and repo rate at 7.75 per cent respectively). Is it correct to infer that Indian macroeconomy parameters and policy should be similar to sub-Saharan Africa or Pakistan and Sri Lanka?
Second, the average real rate in the world (125 countries) is 1.4 per cent.
Excluding sub-Saharan Africa and South Asia, the average drops to 0.8 per cent (89 countries).

Third, The Economist every week documents financial indicators for 42 major economies. If the three “problematic” economies of Argentina, Venezuela and Ukraine are excluded, the average representative real repo rate is only 0.3 per cent. Excluding the developed countries from this average, the “representative” real repo rate increases to 0.8 per cent.

A conservative conclusion for the comparable real repo rate for India is 1 per cent. In order to determine the desired or comparable nominal repo rate, one needs an estimate of future inflation in India. The IMF estimate of mean CPI inflation for comparable economies (excluding developed economies) is slightly less than 4 per cent for each of the next three years. This estimate was made in September 2014, well before the decline in oil prices. Given that extraordinary food inflation is out of the Indian economy, it is reasonable to assume that the upper bound on average Indian inflation is less than 4.5 per cent. This means that the comparable nominal repo rate in India is 5.5 per cent, or that 225 basis points of repo rate cuts are what one should expect in 2015 — if Rajan does not change the goalpost of comparable economies.

The writer is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company