Now that the
repo rate has been cut for the third time this year, the policy stance has turned accommodative, and liquidity has turned surplus, perhaps it is time for the Reserve Bank of India (RBI) to pause and not rush immediately to cut again anytime soon. Here’s why: 1. The repo rate is now at a 10-year low. The rate was last at 5.75 percent in July 2010. Also in India’s history, repo rates have been below 5.75 percent for only 18 months between January 2009 and July 2010. At that time we were responding to a rather unprecedented global crisis. Also, the high level of liquidity surplus in those 18 months (ranging over one lakh crore in most of the weeks) led to near double-digit inflation for the next four years culminating in an FX crisis in 2013. Short point if we are at rates last seen in the aftermath of the Lehman crisis, it is time to at least pause and reassess. 2. Yes, our rate cuts have come at a time of unprecedented fall in yields globally indicating widespread fears of a slowdown. Yet only two days back Mohammad El Erian, chief economic adviser at Allianz, no less, raised the prospect of spring back of inflation. El Erian argues that the deflation of the last few years is probably a one-off impact of a bunch of technological disruptions including Google and Amazon and once these benefits of cheap search and easy buy have been juiced, the world may limp back to inflation. That is global inflation may mean-revert. 3. It is instructive to see the Indian mean inflation. Assuming consumer price index (CPI) (Industrial workers) as the proxy for the new integrated CPI, average CPI in India over the past 50 years has been over 7 percent. Even if we take the last 30 years, since the great reforms of 1991, average inflation has been close to 6 percent. The sub 4 percent inflation has only lasted for the last 24 months. A mean reversion is not out of the realm of possibility. 4. A key ingredient that may engender a crawl back of inflation is the fisc. The math is not adding up, if we took the interim budget numbers as the base. FY19 central tax collections are a full 1 percent of gross domestic product (GDP) below estimates. In fact, as a percentage of GDP tax collections in FY19 were lower than in FY18. On this low base of FY19, we have to do a 25 percent rise in taxes to reach the FY20 tax collection target of Rs 17 lakh crore estimated in the interim budget. Looks very tough as the first quarter is already a washout. If the fisc is going to be loose, surreptitiously or overtly, a fairly quick climb of inflation can't be ruled out. The memories of the 2009-2011 period of fiscal and monetary looseness is all too green for us to forget the lessons. 5. Oh yes, there is the real rates argument. A bunch of stock market aficionados told us that with inflation now forecast at 3.7 percent for the year, we are still left with 200 basis points real rates, too high given our anemic growth. Well firstly, after surprising the RBI on the downside for the last four years, inflation may now well surprise on the upside. Wholesale price index (WPI) food inflation in April is already at 7.37 percent, while vegetables WPI touched 40 percent. More importantly, even if overall CPI food inflation is low at 1.1 percent in April, it has been rising and urban food inflation is already up 4.64 percent. Food CPI, let us remember, also suffers from a huge weight of 12 percent for cereals, where the government procurement works. Such procurement doesn’t work in the next heaviest food item i.e., vegetables. Short point let us not get carried away by the low CPI number and the real rates argument. CPI may creep up faster than we expect. 6. Now if the real rates are so attractive should not banks be getting:
Hand over deposits fist. That’s not happening in part because household savings itself, according to RBI data, is slowing. Adding to that, the government gives far more attractive rates of nearly 8 percent on small savings instruments which are increasingly attracting more household savings. Yes, interest rates offered on household savings is to be legally adjusted to the government securities rates, which will probably be done. But yields on government bonds also aren’t falling as fast as the repo rate because of the sheer mammoth borrowing by the centre, states and public sector units like the Food Corporation of India (FCI) and Power Finance Corporation (PFC). Together these entities accounted for net borrowings of over 10 lakh crore in FY19, while the total growth in bank deposits last year was 12 lakh crore. In short, government bond yields don’t fall much because governments and government-owned units are borrowing too much. And because government yields are high, small savings interest is high and this, in turn, keeps bank deposit rates high. Hence even if we risk more repo rate cuts, it may not be transmitted very soon.
The way forward, therefore, is to pause on interest rates for a bit and let the government fix the real economy. The government should complete stranded projects, work with states to ensure better collection of discom dues, prevent power theft, work together on labour-intensive areas like food processing, etc... and thereby push up productivity, growth and savings. In stock markets, prices are close to their top when the last bear turns bull. In monetary policy, the cycle of rate cuts should be paused, when the last hawks (Chetan Ghate and Viral Acharya) turn doves.
7. Finally, maybe we are pinning too much blame on high rates. Finance costs do not form a large part of corporate profits. Large companies are not investing because rates are high but because demand is slow.