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JPMorgan expects rate cut by RBI in February policy review

Updated : January 16, 2019 06:19 AM IST

JPMorgan on Tuesday said it expects rate cut by the Reserve Bank of India (RBI) at the upcoming policy review in February this year.

In an interview to CNBC-TV18, Sajjid Chinoy, chief India economist, said there is a lot of agrarian distress as the terms of trade have moved sharply against farmers.

Sonal Varma, managing director and chief India economist at Nomura India, said, "For February, we do think there is still a decent probability of the RBI changing its stance back to 'neutral' and our base case view is that there will be a rate cut, but only in the third quarter of 2019 and not immediately."

Edited excerpts:

Q: How impressed are you with the inflation numbers. Can we expect a rate cut in February?

Varma: Impressed at the headline level and not very impressed at the core level. So, we do not think rate cut is coming in February. It is surprising that the growth side indicators are now clearly pointing to a slowdown that is underway and not just in India, but globally most indicators like export growth rate in a lot of countries has been negative in December. So, the growth slowdown numbers seem to be there. But despite cost side pressures coming off, the question is why core inflation is so sticky, because typically that’s a sign of demand still being very strong.

When we drill down into the numbers, it does seem like rural health and education is driving core inflation. So it’s not a broad based. Typically, if you are seeing demand push inflation, you should see a broad based inflationary pressures across all categories and that’s not the case. There are specific categories that are driving this.

One suspicion we have is that generic drug prices have gone higher, because that is the category which has a higher weight in rural areas and that potentially explains why heath prices have gone up. We do not know the reason, but the point and the fact of the matter is that core inflation being elevated does not gel with the demand conditions and lower commodity price pressure. So, our broader assessment is still that core inflation will come off and the current persistently high core inflation that we are seeing is a result of specific idiosyncratic factors and some lagged effect of past high prices pass-through still going on, but that’s not going to be a sustainable scenario. Therefore, for February, we do think there is still a decent probability of the RBI changing its stance back to neutral and our base case view is that there will be a rate cut, but only in the third quarter of 2019 and not immediately.

Q: Do you think the plunging inflation numbers open the door for more monetary easing?

Chinoy: I do not think growth is as weak as we think it is and that is a view we have had now for several weeks. If you just look closely at the high frequency data in India, the PMI surveys have held up at quite a high level, bank credit growth has picked up very smartly and offset at least some if not all of the NBFC has slowdown.

The problem is, if we look at year-on-year (YoY) numbers over the next few months, we get a very deceptive impression of the economy, because this was the same time last year that we had post GST restocking and growth picked up very sharply. So, IIP (3.45) is a classic case in point. You look at the YoY number last week and you will feel growth is plunging. But if you look at the sequential momentum, IIP growth has picked up in the last 4-5 months.

For me, I take Sonal's caveats about this particular core inflation print being driven by health and education, but it's not this month alone, it has happened for three successive months now. Two months ago, the momentum was 1 percent month-on-month (MoM), last month it was 0.5 percent MoM and this month it is 0.8 percent. So for me, this is not so much of a surprise. We always believe growth is not as weak as we think it is. Output gaps are closing fast and therefore for me the fact that there is some pricing power is really not a surprise.

All of that said, the MPC focuses on headline inflation and that has been their mandate and they have repeatedly said that they want to keep the inflation number close to four percent. The fact is, given the quantum and the breadth of the food disinflation, even accounting for core momentum being reasonably elevated the next six months, headline inflation at least until August or September looks like it is going to be below four percent.

So if you are an MPC member going to this meeting, you have come in with two soft prints, the next 2-3 quarters look below four percent, my chance is we certainly get a change of stance in February and we get a rate cut either in February or April. The last thing I would say is that output gaps are closing. I think we should be carefully here and what we do not want in 2019 is this inadvertent confluence of fiscal monetary and regulatory easing. That for me is a key risk.

Q: It seems to me that the weakness is selective and that a larger part of the economy is growing well. Therefore, what are your growth numbers and you said that you are expecting a rate cut in Q3. Is that calendar?

Varma: Its calendar. One is, how things are here and now and the November IIP numbers are exaggerating the underlying reality. However, when I look at the incremental growth drivers, the external sector situation at the margin has started to turn negative only in the last couple of months now. The data across the region is showing a synchronised slowdown in the export sector, Chinese data have been quite bad, the tech cycle is turning down and to that extent the Indian export numbers are also going to be weak and there are links between the export cycle, the industrial production cycle and the investment cycle. So, we are potentially underestimating the impact that global demand will have in India going forward.

Second, on the fiscal side, there are upside risks. But if the government is going to try to stick close to 3.3 percent of GDP, that does mean that incrementally the fiscal impulse is going to be negative going forward and even if one account for off-balance sheet spending, the delta is definitely not positive.

Third, while banks are stepping in and they are not giving credit to all sectors. It’s largely the consumer side, where retail lending is going up. So what happens to the SME and the MSME sector? What happens to the commercial real estate sector? Those are specific sectors, which are still credit constraint and that will show up in the numbers in the coming months as well.

So, I think the situation as it stands today does suggest indeed that growth is alright. Maybe there is a bit of a slowdown, but it's not as bad as the headline suggests. But if I look at the incremental growth drivers and what they suggest for the growth outlook over the next 9 months, they are all moving negative. What does it mean for the growth outlook? I think output gap has closed and is essentially a statement of where things stand in the past. Going forward, our view is that the growth will head towards 6-6.5 percent by mid-2019, which means that output gap will start to widen again.

Q: Do you think concerns around fiscal profligacy are increasing as it generally does during election time with all this talk about farm package, etc. and do you think it will be hard for the government to sort of meet their fiscal glide path?

Chinoy: Two points and I think we should separate this year’s fiscal target. I think the government is very keen to stick to this year’s target of 3.3 percent. I am not sure, given what was budgeted that we will have so much of an expenditure compression to get there. However, even if we do, that is a two month phenomenon.

The bigger worry is I think is that there is is a philosophical shift and may well be warranted that there is a lot of agrarian distress we have seen. The terms of trade have moved sharply against farmers and I do not think we have the administrative capacity to for example, to push up MSPs or to push up market prices towards MSPs. So, there is a growing clamor now across the board to actually have farm income support. The question is, how will that be paid for? I am talking about the next fiscal year. If that is paid for theoretically by some transfer from the RBI surplus for example, we should not conflate the deficit with the impulse, because the deficit will not change. That will be paid for by these transfers. But in fact, the fiscal impulse will be very large. So, I do worry about that.

The second point I will make is, if you step back, people focus so much or fixate on centre’s deficit. The real action has been on the states and off balance sheets. If you add up centre, state, off balance sheets and public sector enterprises, the consolidated deficit is 8.2 percent of GDP, exactly where it was five years ago. So, we do not have much fiscal space.

The last thing I will say is I agree with Sonal Varma of Nomura India on some of the global risks. However, things have moved domestically as well. I am not stating that there is no sectoral stress, there is SMEs and farmers. But the fact is oil is today at $60 per barrel versus $80 per barrel and that does provide a positive terms of trade impulse. You will see margins go up, household purchasing power go up, monetary commissions in India have eased meaningfully over the last 8-9 months, bond yields are down 70 basis points now and the trade weighted currency is depreciated 8-9 percent this year. So, I think there are some tailwinds for the economy going forward.

Q: Date wise, the budget comes first and then comes the monetary policy committee meeting. Therefore, do you think there is a cut or no cut in February or no cut at all?

Chinoy: No, we believe there will be one cut. I just think the headline numbers are too compelling for the MPC to ignore since they are focused on headline. I think in February, we certainly get a change of stance. Our base case is it is just easier to go ahead and cut in February baring there is no unpleasant surprise on the fiscal.

So assuming on February 1, the government sticks to 3.3 percent and next year’s deficit is lower 3.1 percent, I think it might be easier for the MPC to acknowledge the quantum of the undershoot in the last four months, cut rates once and then buy themselves time over the next 3-4 months to figure out what is happening to growth, inflation, fiscal and oil prices. So, we have one cut in our forecast between February and April, it is a close call, but our base case is February.

Q: Look at the way the MPC is positioned. We know that Dholakia has been dovish and with 2.19 last December reading, he is mostly likely to route for a cut. The new governor also sounded very dovish, when he spoke to the press the only time when he spoke. He said inflation and inflation outlook is benign. But who is the third vote. It does look like Patra, Viral Acharya and Chetan Ghate are confirmed hawks. So, will he be able to push through the vote with Pami Dua. Do you see that happening in February?

Varma: I agree with you. I think the bar for a cut in February is a bit higher. Directionally, we do think there will be a cut. Bar higher for February, because when the MPC met in December and including the minutes that were released later in December, by then it was very clear that inflation was going to undershoot. So the other five members of the MPC had a chance to give a signal if they wanted to indicate a cut at the next policy meeting and none of that came through. So to move from calibrated tightening, which means that there is no cut to a cut in the next policy would essentially mean that the importance of communication via stance is irrelevant. So from continuity perspective and sequencing perspective, I do not think it makes sense to change the stance which, brings rate cut back on to the table and then follow through with a rate cut. Therefore, the bar for a cut in February is high, but beyond February there should be a cut.

Q: The market borrowing from state governments have gone up and that seems to be the big concern now. I was looking at some numbers and the net borrowing by state governments for this fiscal is estimated to be almost 14 percent higher than what it was last year given that now they have a larger share of fiscal responsibility, some waivered rules with respect to farm loans etc. What are your own numbers, what are you projecting and do you think this is going to be the big concern as far as the fiscal goes?

Varma: It is definitely a medium-term concern, because the fact is that there has been some amount of rollover of subsidies, delayed refunds and various ways to try to meet the deficit target at the centre level year-after-year and beyond centre and states, the issuance of government service bonds via various government companies has gone up. So, when we look at the broader public sector, centre, state and public sector companies and their total borrowing – that is quite high and we are in a macro situation right now where investment demand is still benign, is quite weak in fact at a private level. Where do we go if indeed private investment demand picks up in a big way? There will be tremendous crowing out and that itself can push up interest rates and we need to combine this with a fact that a lot of medium-term fiscal commitments are being put in place now, they may not have an impact immediately, but in the medium-term, they will add to more expenditure, while the GST side revenues will continue to disappoint. So I do think in medium-term, there are fiscal concerns and we need to tackle that quickly even though near term the deficit is being managed.

JPMorgan expects rate cut by RBI in February policy review

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