Interest rates are headed higher despite RBI’s stance

Unchanged policy rate and sustenance of the accommodative stance in the Reserve Bank of India (RBI)’s statement today was on expected lines. However, a broader assessment of growth outlook and inflation was on the neutral side as against expectations of reciprocal responses to the gaining hawkish context for global monetary policy normalisation. Specifically, the market was expecting greater acknowledgment of a quicker tapering by the US Federal Reserve and gaining acceptance of an early rate lift-off in 1H2022.

RBI responded with a fairly calibrated strategy that is pivoted on certain key assumptions:

• While India’s recovery is gaining traction, the path is far away from attaining the pre-Covid real GDP trajectory. Even with the projected 9.5 per cent growth in FY22 and 12.5 per cent in 1HFY22 — which are largely a statistical bounce after the Covid shock — the slack in the economy, particularly on the private consumption side, will still be substantial, thus requiring an accommodative monetary policy.
• The RBI believes that the buffer against the spillover effects of faster monetary policy normalisation in the US is adequate with forex reserves at $638 billion, which can be used to ensure financial market stability and growth supportive liquidity conditions.
• With the focus remaining on headline inflation, which is targeted to remain around 4.5-5 per cent, while underplaying the significance of core inflation, the RBI believes that a well-anchored inflation regime should act as a bulwark against a potential decline in external capital flows.

Based on these assumptions, the RBI’s base case strategy is to sustain a calibrated and non-disruptive normalisation programme, which extends the earlier liquidity neutralisation measures. Hence, the earlier measures of discontinuance of GSAP purchases and expansion of Variable Rate Repo auctions for a longer duration have been enhanced with even larger 14-day VRRR actions of Rs 6.5 trillion (December 17) and Rs 7.5 trillion (December 31). Such actions will continue after December 2021 and will enable the RBI to pace the liquidity supply in line with its normalisation strategy.

In addition to the expansion of the VRRR limits and auctions, other measures towards liquidity normalisation include a) prepayment of liquidity support taken by banks under the LTRO and TLTRO windows initiated in the wake of the Covid shock (RBI says that out of the total borrowing of Rs 1.13 trillion, banks have already returned Rs 373 billion); b) termination of on-tap liquidity facility to the healthcare sector (Rs 650 billion) from March 31, 2022; and c) rolling back the expanded MSF borrowing limits of banks from 3 per cent to 2 per cent of net demand and time liabilities.

In our view, despite the near-neutral tone of articulation, it is clear that the RBI is increasingly moving towards liquidity normalisation, which will continue to imply further hardening of short-term rates. The expected tightening in liquidity due to gains in credit growth by year-end (our assumption of 8 per cent in March 2022 vs 7 per cent now), deceleration of deposit growth (8.7 per cent, 9.8 per cent now), and declining foreign currency assets are likely to move up the long-end G-sec curve as well.

In addition, as the RBI uses the forex reserve buffer to defend the exchange rate, in response to faster QE tapering and eventual rate lift-off, potentially in 2Q 2022, the liquidity normalisation will likely hasten.

Thus, we reaffirm our view that the interest rates in India are headed higher even as the RBI lags in initiating policy rate hikes, which will imply quicker repricing of term deposit rates of banks and finance companies.

Also, the RBI’s statement affirms our view that the private capex cycle is a desirable thing but it is still far away, given the extant large slack in private consumption and the enduring negative output gap. The lack of private capex has been a significant drag on the ability of Indian banks to leverage their overcapitalised balance sheet.

Lastly, while the outlook on headline inflation remains benign (projected at 5.7 per cent in 4QFY22 and 5 per cent in 1HFY23), core inflation has averaged 6 per cent in recent months. Likewise, the current account balance has quickly turned into a deficit (-2.8 per cent of GDP in Q2FY22) after a very short period of surplus of 1.4 per cent in 1HFY21, immediately after the pandemic shock. Persistently high core inflation, above 4 per cent (it was elevated even before the pandemic), and quick emergence of CAD, even while the economy is judged to be substantially below potential, is a concerning combination. This hints at a further decline in the potential GDP trajectory from the lows of 4.5-5 per cent prior to Covid.

Hence, while the RBI is expecting lower core inflation in anticipation of lower taxes on fuel, gains in consumption demand can induce an upside risk to inflation and widen CAD/GDP even further, if indeed the potential GDP is indeed on a slower track compared with the pre-Covid trajectory. Hence, our base case is that the RBI will also initiate rate hikes soon after Fed’s lift-off in Q2 of 2022.