There were expectations that the Reserve Bank of India (RBI) would cut rates in the February policy after the Budget set a fiscal deficit target of 3.2% for 2017-18. The RBI not only surprised everyone by holding rates but also changed its stance to neutral. Badrinivas N.C. , Managing Director, Country Treasurer and Head - Local Markets Treasury, Citi India – which had predicted that the RBI was unlikely to cut rates in order to maintain macroeconomic stability – spoke on the future trajectory of interest rates and the markets. Edited excerpts:
What are your views on the interest rate scenario? How will this impact prices at a time when global commodity prices are firming up?
The indications from the recent RBI policy are that we have probably come to the end of this easing cycle. So interest rates are likely to stabilise around these levels for some time. I assume by prices you are referring to prices of goods and services – inflation. Interest rate policies impact growth and inflation with a lag, typically a lag of at least three quarters. In fact, this lag is one of the reasons given by the RBI for a shift in their stance from ‘accommodative’ to ‘neutral’ – they would like to see the impact of past rate cuts on growth and inflation before deciding on the future course.
How do you justify the status quo maintained by the central bank?
I don’t think it is for me to justify their stance. But if you are asking if I agree with their actions, it is something we actually expected. Our view going into the RBI policy meeting was that the RBI is unlikely to cut rates now. It was based a lot on what they had mentioned in their previous policy meeting in December and also considering the global environment factors.
To understand their stance, it is important to step back and look at how inflation and interest rates have moved over the last 2-3 years.
Since 2014, CPI (consumer price index) in India has come down by around 4.5%-5%. And interest rates have moved lower by about 2% -3% across government bonds, corporate bonds and deposit rates.
In this period, the RBI has also adjusted the real rate framework (the difference between interest rates and CPI) and said that for long term benefit of the economy, interest rates should ideally be 1.5%-2% higher than inflation. Considering this framework and based on their inflation projections which seem to be settling at 4.5%-5% levels, they have come to the conclusion that present policy rates are appropriate and there is no requirement for any immediate rate cut.
Is there any likelihood of the RBI cutting rates in April?
RBI has said their stance now is ‘neutral’ which means they see the next move could be in either direction.
While we don’t see any immediate possibility of rate increase, the hurdle to cut rates is also high. Unless there is some dramatic change in the global and local macro environment, I would think the chances of a rate cut in April are extremely low.
What will be the outlook for rest of the year?
A lot would depend on how the consumption story and inflation pan out in the next few months.
The remonetisation of the economy is ongoing and is expected to lift growth in coming months. The impact of pay commission revisions and also the income tax cuts announced in the Budget are positive factors which could boost consumption. On the other hand, private investment cycle is still weak and the growth pick-up is not broad-based. How all these factors influence the core CPI (inflation ex-food and ex-fuel) will determine how interest rates move and whether RBI will find space to cut rates in future. Global developments, including path of U.S. interest rates and oil prices are also important factors.
Would you say that we have reached the floor on interest rates and no further cuts are possible?
India has seen many years of high retail inflation and high nominal interest rates compared to many other emerging markets.
The fall in inflation in the last three years is a combination of various factors including concerted efforts of the government especially to contain food inflation, fall in global commodity prices, good agriculture production last year, prudent fiscal policies etc. Some of these factors could reverse.
We are already seeing global commodity prices move up. If you look at the month-on-month sequential move on inflation, it does look like ex-food, inflation is sticky around the 4.5%-5% levels.
Drivers of further sustained reduction in inflation are not very apparent. Also, we need significant supply side measures to move the economy to lower levels of inflation. This is still work-in-progress and will take time. Nominal interest rates eventually are a function of the levels of inflation. So, while there can be some move up and down in interest rates from here on, larger move down in rates will be a function of whether we can get inflation down to lower levels on a sustained basis.
What would be the impact (on prices) with the implementation of GST in September?
The expectation is that for most of the commodities in the CPI basket (more than 60% by our estimate), tax rate will be unchanged and for the rest, some will go up and some will come down. Hence, at present, we do not expect much impact on the CPI from GST implementation.
What is the impact of demonetisation on interest rates and prices?
The one big positive impact of demonetisation has been the large growth in banking system deposits. This has enabled banks to reduce lending rates in the last two months, by large quantum in some cases, even though there has been no cut in the policy rates by the RBI since October. I also believe this large growth in financial assets will have a more productive impact on the economy over time.
The impact of demonetisation on inflation is not very easy to quantify. It is likely that prices of some items, especially perishable food, have been impacted but as the remonetisation happens, they should also move back up quickly.
U.S. dollar is strengthening in the aftermath of Mr. Trump’s election as U.S. President. What will be the impact on Indian Rupee? What would be the outlook on dollar – rupee exchange rate?
The initial dollar strength on the election of Mr. Donald Trump has faded a bit in the last few weeks as the markets await specific policy announcements from the new administration. If the Trump administration does come with strong tax cuts and fiscal policies that they promised earlier, the U.S. dollar could resume strengthening and that will have a negative impact on the rupee. But it is important for readers to understand that exchange rate cannot be viewed purely from USD-INR perspective. What is important is to look at the Indian rupee against a basket of currencies to see how competitive it is. The external macro variables for India continue to be good with a low current account deficit, reasonably good growth and low inflation compared to the past. This bodes well for India to continue to attract global flows as an attractive investment destination. Though there is likely to be volatility, Indian rupee is expected to perform reasonably well in comparison to its peers.
What is your outlook on gold and oil?
Typically gold price movements are converse to U.S. dollar. So, if US dollar were to resume strength, gold prices are likely to stay soft, which is the base case outlook of our commodities team. However, if inflationary pressures build up in the advanced economies, gold prices could turn upwards. On oil, the base case view is for prices to remain firm and probably inch upwards towards $60-$65/bbl by end of this year.
So, in conclusion, what would be the two or three key factors that you would watch for in the coming months?
The most important, I guess, will be the policy announcements by the new U.S. administration and their approach to global trade. A lot of that will feed into U.S. federal policy, emerging markets flows, global growth dynamics etc and hence will be the key driver of most markets. From a domestic perspective, the pace of growth pick-up post remonetisation and the monsoon outlook will be important factors to watch out for.
