View of the Month - July: Awaiting a rated move
Based on Edelweiss' recent interactions with investors, the street is divided on the possibility of rate cut. In fact, Mint Street’s action has led few to believe that there will be no aggressive rate cuts in the current fiscal as RBI continues to target headline inflation. However, their view remains that the central bank should resort to aggressive easing in the current year.
First, core/demand inflation has declined sharply over the past few months, pointing to slowing demand and receding price & wage pressures. Indeed, as per Edelwiess' calculations (based on re‐arranged WPI basket), domestic demand‐led inflation has plunged sharply from 6‐7% to 2.5% over the past few months (much below its historical average of ~4.0‐4.5%). This implies that any rise in headline inflation on supply‐side issues (e.g., higher agriculture prices due to low rainfall) is unlikely to translate into generalized inflation pressure as intermediaries/businesses lack pricing power. In such a scenario, RBI’s focus on headline inflation is misplaced and consequently it will have to refocus on core/demand inflation where the declining trajectory begs a reduction in interest rates.
Second, supporting growth is clearly a priority. A host of recent data releases like GDP, IIP, auto sales, declining corporate margins and upturn in the NPA cycle, especially in SMEs (which account for ~18% of the total NPA in contrast to ~10% of their share of banking credit), are indicative of the economy currently growing much below potential (further corroborated via declining core/demand inflation).
If this state of affairs is allowed to continue, it could be detrimental to the medium‐term growth trajectory. In fact, Edelweiss believes, overly tight monetary conditions will become extremely counter-productive. Fiscal deficit will worsen (as tax revenue falters due to weakening growth), investment slowdown will deepen (hurting medium‐term growth trajectory) and inflation could become stickier (as high interest rates hinder capacity creation).
In other words, growth revival is now vital to improve the economy’s overall dynamics, be it fiscal deficit or boosting investments and sentiments or attracting capital flows. Accordingly, aggressive easing of policy rates to support growth is crucial at this point in time (considering lag effect).
Third, economic data of the past few months confirms that the global economy is losing steam at a faster rate than anticipated earlier and the downturn is synchronised. This could severely hit India, if RBI fails to adopt a flexible and proactive approach. Various central banks such as Bank of England, ECB, PBoC have already initiated steps to ease monetary conditions further. Moreover, a weak global economy points towards continued softening in global commodity prices.
There are a few arguments against rate cuts. First, credit deposit (CD) ratio is elevated currently and hence, any reduction in policy rates could worsen it. Edelweiss is of the view that policy rates are not the reason behind sharp spike in the CD ratio in recent months and, therefore, cannot be the solution. Typically, the CD ratio tends to stretch when domestic demand overheats; in which case, raising interest rates makes sense. However, currently, the domestic economy is actually quite weak. In their view, the reason behind the stretched CD ratio is that as capital fled in H2CY11 amidst escalation of the European debt crisis, domestic businesses responded by either paying back their maturing foreign debt via internal savings or resorting to domestic borrowing to replace the maturing external debt. This triggered an unusual rise in the CD ratio. It is no coincidence, therefore, that the CD ratio began its upward march since August 2011, when the European crisis escalated. Therefore, keeping rates elevated will not address the imbalance in the credit and deposit. As and when outflows stabilise, the CD ratio should begin to decline, as happens in a slowing economy.
Another argument often offered to keep policy rates elevated is the need to support the INR. Edelweiss believes this too is not an appropriate policy prescription. To the contrary, elevated interest rates would hurt growth, fiscal consolidation and increase macroeconomic vulnerability of the country, thereby hurting capital flows rather than encouraging them. History offers enough evidence in this regard. At the height of the Asian Financial Crisis, IMF made the same policy prescription to Asian economies (keep interest rates high to support currencies), but that policy misfired badly as it led to sharper economic contraction and currency devaluations. The approach was severely criticised by various scholars such as Joseph Stiglitz, among others. Further, capital flows attracted by high interest rates will be fickle in nature compared with those which accompany a better growth environment. Accordingly, in Edelweiss' view, reducing interest rates will be a more fruitful strategy to support INR, than keeping them elevated.
In a nutshell, contrary to general expectations, Edelweiss expects Mint Street to undertake aggressive monetary easing this year (~75‐100bps in rest of FY13) as the domestic economy is operating far below potential and lag impact of high interest rates will continue to linger. This will keep core inflation under check. Besides, the global macro and financial market environment has worsened materially, adding to downside risks related to the domestic economy while global commodity prices have softened even in INR terms. Continued high interest rates at this stage will do more harm than good.
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Edelweiss is one of the leading financial services company based in Mumbai, India. Its current businesses include investment banking, securities broking and investment management. They provide a wide range of services to corporations, institutional investors and high net-worth individuals.
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