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A cut in time

Low rates will help. But sustainable higher growth requires the government to debottleneck sectors and push through pending reforms.

Written by Dharmakirti Joshi , SakshiGupta |
February 3, 2015 12:00:14 am
The factors that will keep inflation low next fiscal and beyond will include government measures, such as lower increases in the MSP and better utilisation of food grain stocks. The factors that will keep inflation low next fiscal and beyond will include government measures, such as lower increases in the MSP and better utilisation of food grain stocks.

India’s macroeconomic scenario is changing for the better, with growth seemingly picking up and inflation easing significantly. This is the opposite of what had happened in the last few years.

Indeed, the present combination is a unique blessing for India, and another tailwind was added when the Reserve Bank of India (RBI) surprised all with a rate cut on January 15. As a result, we expect India to clock a GDP growth of 6.3 per cent in 2015-16.

The RBI’s out-of-policy move to reduce the policy rate by 25 basis points to 7.75 per cent raises three questions. What prompted it? How much of the cut will transmit to lending rates and goad economic activity? When will it cut again?

The December prints for both consumer price inflation (CPI) and wholesale price inflation (WPI) confirmed that the downward momentum in prices is strong enough to offset a statistical setback — that of the benefit of high base-effect ending. Core inflation also declined as per the two indices. Second, oil prices slid significantly last month to below $50 per barrel. On January 15, the price of the Indian basket of crude stood at $43.36 compared with $70 in early December. Additionally, the outlook on oil has turned more bearish because of a quantum surge in supplies, which suggests the current decline will last longer.

Meanwhile, an RBI survey of households in December showed inflation expectations — for three months as well as a year ahead — have reduced significantly; they see it staying around current levels.

Interestingly, this is the most broad-based plunge in inflation in the last six years. To be sure, prices did decline sharply in 2009 in the aftermath of the global financial crisis, but only when measured using the WPI. This time round, the fall in WPI inflation is accompanied by a mirroring decline in the CPI. Present dynamics also show that measures of core inflation — the CCII (Crisil Core Inflation Indicator), an alternative measure of core inflation calculated by removing metal prices from the prices of WPI manufactured articles, and the WPI Non-Food Manufacturing Index — are converging unlike in 2009. This underscores the generalised nature of the current disinflationary trend, and strengthens the case for lower policy rates.

We expect the RBI to cut rates by up to 50-75 basis points over the next 12 months, with the next cut possible in the forthcoming policy. Future action hinges on the government’s fiscal consolidation efforts and measures to improve the economy’s potential so that higher GDP growth does not set off fresh price fires.

We expect inflation, which has fallen below the RBI’s expected trajectory in recent months, to average 5.8 per cent next fiscal — and comfortably inside the 6 per cent CPI inflation target set by 2016. This is predicated on a benign outlook for crude, a normal monsoon, proactive steps by the government to control food inflation, and better monetary and fiscal coordination.

We foresee Brent crude averaging $60-65 next fiscal, compared with around $85 in this one. Our calculations show for every 10 per cent decline in petroleum prices, CPI inflation declines by 20 basis points. This is the first-round effect. The second-round effect of lower production and transportation cost will also play out. If a normal monsoon follows, not only will it support farm growth but also keep food inflation at bay.

The factors that will keep inflation low in the next fiscal and beyond will include government measures, such as lower increases in minimum support price (MSP) and better utilisation of food grain stocks. The lack of such measures in the last few years (for example, there were huge increases in the MSP) had led to high food inflation. Going ahead, the government needs to take further action to remove supply-side inefficiencies and reduce wastage to bring down inflation sustainably. Another factor is better monetary and fiscal policy coordination. India’s fiscal deficit is also expected to come down next year, as the government moves on the path of consolidation.

The RBI recently said the methodology used by banks to arrive at their base rate — or the minimum lending rate — should be revisited every three years instead of five now, and banks should stick to approved policy for setting lending rates over the base rate for different categories of borrowers. This is expected to improve policy transmission in a transparent manner.

In our opinion, the future transmission of rate cuts — after a proportionate reduction in lending rates by most banks — will hinge upon the extent of risk aversion among banks. High non-performing assets (NPAs), particularly at public sector banks, have made bankers chary, and thereby hindered policy transmission. Lending rates typically exhibit downward rigidity during monetary easing due to high cost of past deposits. These rigidities plus high NPAs will delay the benefits of easy liquidity conditions and lower policy rates to be passed on to the borrower.

Another reason we believe the recent rate cut and comfortable liquidity are unlikely to trigger a sharp bank credit growth immediately is because money market rates are already 100-150 bps below bank lending rates. The base rates of banks have been steady around 10-10.25 per cent over the last 18 months, while deposit rates started coming down last October by about 20-25 basis points because of ample liquidity. What the RBI’s mid-January rate-cut did is push banks to lower deposit rates further to maintain their spreads.

While low rates stoke an economy, India can move into a sustainably higher growth trajectory only when there is unflinching focus from the government on quickly and effectively debottlenecking sectors, pushing through pending reforms and coming out with seminal steps to facilitate a structural reduction in bad loans at banks

Only then will the much-needed private-sector investments begin and set off a virtuous cycle.

Joshi is chief economist and Gupta, junior economist, Crisil Ltd. 

Views are personal.

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