RBI Monetary Policy: India's twin challenges makes a case for rate hike; What will be our next policy repo rate?

We are just few hours away for the announcement of India’s fourth bi-monthly monetary policy of FY19. The RBI governor Urjit Patel along with Monetary Policy Committee (MPC) will be announcing the policy stance, repo rate, CPI inflation outlook and its view on global economy and markets. The MPC members have been meeting for the last two days, and today they will be presenting their decision at around 14:30 hours. Ahead of the policy, the Sensex has cracked below 35,000-mark, and was trading 34,980.85 down by 188.31 points or 0.54%. The benchmark has plunged by as much as 256 points in few minutes of opening. Meanwhile, the Nifty 50 was trading at 10,492.50 lower by 106.75 points or 1.01%. 

Majority of experts believe that once again RBI will hike policy repo rate, which is currently at 6.50%. The last time this policy repo rate was seen in April 2016 policy. 

A poll carried out by Zee Business reveals, that about 70% experts are hoping for a rate hike in today policy, while remaining 30% believe Patel may decide to keep a status quo. 

Interestingly, there are factors that do indicate a rate hike is on the cards, and even the policy ways of meeting suggest the same case. Since past two policy, RBI has been meeting for three continues day in order to present the country’s bi-monthly policy, earlier it was just two days. 

Well, the trigger lies in RBI’s hand and what will be the new policy will be keenly watched. However, the real question is by how much Patel can afford to hike a policy repo rate. 

To begin global factors, the US data  suggests growth is likely to pick-up in the near-term thus driving US yields and currency higher. US Federal Reserves assessment on the country’s economy is upbeat. If US is going to stay on bullish, it would be a concerning factor for India, as this would means that higher CAD and inflation.

US Fed further tightened the monetary policy and raised interest rate by 25 bps to a range of 2.00% to 2.25%. There is another rate hike expected from US central bank by end of December 2018. 

Bank of Baroda says, “While yields fell because of reduction in government borrowing (Rs 200bn below est.) in H2 and OMOs of Rs 360bn for Oct’18, the macro backdrop suggests yields are likely to move higher than lower. With INR falling by 5.6% and oil up by 14% since last policy, we expect RBI to hike rate by 25bps on 5 Oct 2018.”

Explaining of US further rate hike, Karvy Stock Broking said, “ Though, we believe that this has been largely factored in 10-year Indian Govt bond yields, we still think that Indian/emerging market investments may be impacted on the back of political/trade concerns.”

That said, it can be known that, Indian economy is facing twin challenges. Firstly, the crude oil prices and depreciating rupee. 

Recently, the CPI or retail inflation eased to 3.69% during the month of August 2018 lower compared to 4.17% of the previous month. While  core CPI inflation (ex. Food and fuel) also eased slightly to 5.8% Y-o-Y from 6.2% Y-o-Y in July. 

source: tradingeconomics.com

Sure the easing of CPI due to food inflation brings some comfort for RBI, however, the twin challenges that haunt India to an extreme level cannot be ignored. Not to forget, these dilemmas will impact CPI in future ahead, which will make it difficult for RBI to maintain inflation well within its target. 

Since the August policy, the Indian currency has depreciated by 8% against US benchmark dollar index at interbank forex market. Meanwhile, from January 2018 to till date, the rupee has weakened by 13% against the dollar. 

A 5% depreciation in rupee is believed to impact CPI by 20 basis points, as per RBI. Shockingly, few analysts believe the pressure of rupee could be much higher. 

Vivek Ranjan Misra and Jayasree Ram analysts at Karvy Stock Broking said, “We believe that the genesis for the turmoil in the currency markets has its origins in the wider emerging market space. Firstly, as part of trade war, USA imposed import tariffs on China, Europe, Mexico, Canada and Turkey. Secondly, economic imbalances in certain markets like Argentina led to increase in interest rates and had to approach the IMF for a bailout.”

The duo at Karvy added, “This has led the currencies of emerging markets to depreciate significantly. Lastly, strong US growth (US economy expected to grow at 2.9% in 2018), higher US rates and strong corporate earnings growth with S&P 500 earnings expected to grow at 16.6% in 2018 have increased the attraction of US assets leading to the strengthening of US Dollar.”

After carrying out a study on relationship between Rupee and consumer price inflation, Karvy suggest that the current spell of INR depreciation may lead to inflation being higher by 75 bps compared to the baseline scenario over a period of six months. 

Karvy adds finally, “If the Reserve Bank wants to maintain a constant real policy (nominal –CPI) rate, it would need to deliver 2 to 3 rate hikes of 25 bps each. We expect another rate hike of 25 bps on 5th October, 2018 while not ruling out even a 50 bps increase.”

Along with this, the boiling international crude oil prices with Brent crude crossing USD 82/barrel are putting enormous pressure on India’s current account. 

Sahil Kapoor, Shobana Krishnan  and Ashutosh Gehlot  analysts at Edelweiss said, “CAD is expected to reach 2.9% of GDP in FY19. Such a deteriorating BOP position and INR depreciation requires urgent consideration from the MPC and may warrant a rate hike.”

Furthermore, liquidity position of banks will play a spoilsport, and add another pressure on RBI. 

RBI has increased the facility to avail liquidity for Liquidity Coverage Ratio (FALLCR) limit by 2%, taking effect from October 1, 2018, from the existing 11% to 13%. This will take the carve out from SLR available to banks to 15% of their NDTL. Secondly, Rs 200 billion of OMO purchases in the month of September 2018, with another Rs 360 bn announced for the month of October, leading to FYTD OMO purchases of Rs 860 bn till end of October. 

In this regards, Kamalika Das and Anushri Bansal, analysts at ICICI Bank said, “ With our full year expectations of OMO purchases of Rs 1.6 trillion, we expect the system liquidity at a deficit of ~Rs 2.5 tn by March 2019.

Apart from liquidity, ICICI Bank also explains that, the recent NBFC liquidity crisis and rising oil prices impinging the nascent growth recovery could play on the members’ minds, according to us 1) the rally in oil prices (have risen by 19% since the last policy) 2) Rupee depreciation by ~8% since the last policy 3) elevated inflationary expectations with upside risks 4) elevated core inflation, averaging ~5.9%, could prompt the members to increase rates in this meeting. 

Thereby, ICICI Bank said, “We expect the October 2018 MPC to vote for a unanimous 25 bps rate hike with a change in stance.”

Moreover, analysts at Edelweiss said, “While raising rates would counter the declining INR trend and the deteriorating BOP position, it would lead to further liquidity stress in the market. RBI has already done OMO purchases of INR 51k crore this fiscal and has announced plans to infuse further liquidity of INR 36k crore in October, in order to counter the liquidity deficit in the market and ease the sky high bond yields. RBI will have to balance the two misaligned objectives.”

Having similar views like above, Dr. Soumya Kanti Ghosh, Group Chief Economic Adviser at SBI said, "We believe October rate hike of 25 bps is imminent, but the question is whether the magnitude of rate hike could be even higher by 25bps (say 50 bps).”

This means RBI can hike rate either by 25 basis point or even scare the market by 50 basis points. If this the case, India’s next policy rate can be 6.75% or 7% which would be at three-year high.