It is not the first time we have heard of discordance between the RBI and the government over policy interest rate decisions.
In the latest, while the government thinks that policy rate at 6.5 per cent is “very stressful” and inhibiting private capex, RBI has warned against premature easing as it would undo the gains in reducing inflation, averaging 4.5 per cent this year vs the five-year average of 5.8 per cent.
The central bank accounts for upside risk from higher food inflation, geopolitical disturbances, and higher crude prices. The renewed debate emanates from the surge in inflation to 6.2 per cent in Oct’24 on the back of rising food inflation (9.7 per cent). The pressure on the RBI is to ignore the headline and cut rates in line with the core inflation to 3.7 per cent, i.e., inflation excluding food and fuel, which is lower than the mutually agreed target of 4 per cent.
Such dissensions are not normal. It typically erupts on occasions when the economy is faltering but inflation is elevated.
Earlier, D Subba Rao was pressurised to tone down inflation projections to allow for rate cuts. During FY12-FY13 inflation ranged at 9-10 per cent and RBI held the rate high at 8-8.5 per cent, while the economy slowed to 5.5 per cent and private consumption to 7 per cent; India was characterised as “Fragile Five” amid the US “Taper Tantrum” backdrop.
Raghuram Rajan was heavily criticised for not allowing for a steeper rate cut in 2016 following the 150 bp easing to 6.5 per cent when inflation slowed to 5.8 per cent and real GDP growth ranged at 7.4-8.0 per cent. His regulatory tightening was a bigger source of criticism. These were seen as factors inhibiting private capex.
So, why is the same story playing out now, is the economy stressed?
The official stance is that the economy is thriving, and the extant slowness should not cause “excessive worry”. That draws from official real GDP growth projections of 7 per cent and resonates with Moody’s assessment that the Indian economy is in a sweet spot. Earlier, RBI posited India being in a take-off stage.
Are corporates in stress?
Corporate balance sheet, and profitability have not been as robust in the past 16 years, thanks to the post-Covid exuberant profits on the back of policy bounties and the K-shaped economic rebound aided by premium price surge. Financial conditions have remained favourable for nearly a decade, recently due to a favourable market situation that has allowed monumental fundraising at high equity valuation funded by retail investors and narrow credit spreads over sovereigns enabled by institutional investors and banks. Before Covid-19, the nationalisation of non-performing private debt, corporate tax cuts, and recapitalization of banks also enabled the deleveraging of balance sheets. Consequently, interest expense of listed non-finance companies as a ratio of net sales has declined to 2.1 per cent in 1HFY25, lowest since FY11.
Indeed, as the Economic Survey points out, profits of non-finance companies multiplied four times over the pre-COVID levels, while their investments in machinery, equipment and IP products were up just 35 per cent in the four years till FY23.
What about the banks?
Thanks to the post-pandemic push from the central bank and improved cash flow of corporates, banks also accumulated a large capital base and reported strong profit gains as they wrote back provisions for NPAs. The excess liquidity profusion by RBI, rising to a high of 5-6 per cent of bank deposits, along with a host of forbearances enabled banks to reduce fixed deposit rates to saving deposit rates, enabling them to earn hefty margins.
The margin erosion they have been facing in recent quarters and their scamper for deposits are thus a payback for their past exploits. Their problem is that corporates have dithered from capex-driven credit and hence, on a higher capital base they have had to push retail, mainly uncollateralised loans.
Consequently, they have reached a peak credit-deposit ratio of 80 per cent (including HDFC merger), burdened with the onset of a retail default cycle. Foreseeing the credit and asset-liability mismatch risks, RBI has tightened credit norms; microfinance companies and NBFCs are already into the cycle.
Is the government stressed?
The FM recently assured that India’s government debt levels, including that of states, are prudent going by debt sustainability norms; at 81 per cent of GDP in FY22, it compared with 260.1 per cent for Japan, 121.3 per cent for the US, 111.8 per cent for France and 101.9 per cent for the UK. Additionally, the share of short-term debt in total external debt is 18.7 per cent, lower than that of China, Thailand, Turkey, Vietnam, South Africa, and Bangladesh. (see here)
It is thus confounding why the RBI is facing the type of coercion typically seen during fragility, while the claim is of a robust economy.
Or is the reality different from the narrative?
Recent voices from consumer companies questioning the relevance of strong GDP print for their respective industries, viz. paints, passenger vehicles, baby food, noodle manufactures and a whole host of retail chains, emphatically point towards household distress.
Real private final consumption expenditure has been averaging at 3.5-4 per cent over the past five years despite the exuberant leveraged spending. And while the contraction in financial savings was seen as a sign of improving household confidence, it ironically accompanied a languid actual consumption, indicating faltering real incomes.
Indeed, the annual periodic labour force survey (PLFS) and RBI KLEMS database shows that real earnings per worker contracted by a CAGR of 1.6 per cent for the five-year ending FY24. Budgetary constraints have pushed workers towards less productive disguised unemployment in rural areas, particularly in agriculture, thereby reversing the structural transformation. Average worker earnings, accounting for wage rate and higher worker participation rate, particularly of women has enables real worker earnings growth of 3.5 per cent. The Household Consumption Expenditure Survey 2023-24 also indicates average real consumption growth of 3.5 per cent CAGR since 2012-13.
Distribution of individual income tax filers shows that average income growth from all sources, including salaries, business income, earnings from deposits etc. was a modest 5.6 per cent over the decade ending FY24, barely matching inflation. Earnings from equity markets for an average earner remains low at 5 per cent despite the robust expansion. And incomes for the upper end, greater than 9.5 lcs have grown rapidly while for the majority it has growth less than the average inflation.
The irony is that while major companies are reporting low single digit growth, GDP data estimated a steep jump in real personal consumption expenditure to 7.4 per cent in 1QFY25.
While the above characterizes heavy lower arm of India’s K shaped recovery, it contrasts the robust but slender upper arm, mainly comprising of the affluent earners who also have credit access. But with corporate earnings now contracting, spending on worker compensation has also slowed, thereby also slowing urban demand.
So what is camouflaged by the robustness of corporate situation, and well capitalised banks is the persistently stressed Indian households whose income constitute 78 per cent of India’s GDP. The other dimension of this stress is that the burden of fiscal consolidation from a high level of public debt, estimated at ₹270 trillion or 90 per cent of GDP, is on the households for whom the tax outgo has been higher than what the corporates paid for profit upsurge.
So, the unease over stressfulness is probably misidentified. It is not amongst the corporates. And having seen several rate easing cycles over the past 12 years and abundant cash balance, it is unlikely that their investment intent is inhibited because RBI is refraining from rate easing now.
The debate over splitting RBI’s target between food and core inflation is facile. Given that the 4 per cent headline CPI inflation target was mutually agreed between the RBI and the government in 2016, an arbitrary shift in goalpost will be impudent.
It will be worthwhile to consider RBI’s recent research highlighting the core type characteristics in high food inflation and its spillover effects on core inflation.
And lastly, the reason for persistently high food inflation despite record agriculture production (FY25 is projected to grow by 5%), much higher than the population growth of 1.1 per cent, is indicative of higher food demand and reduced surplus.
The reason why core inflation is low is because consumer companies had already ratcheted up product prices exorbitantly through premiumisation and shrinkflation, and are now faced with budgetary constraints of households who have to now spend more on basic items like food. The fact that they are still at multi-decade peak margins indicate their high pricing power, which can be utilized to push up prices at the earliest opportunity.
Does interest rate cut help in resolving the bigger structural problem faced by households? Probably not. It will definitely be ineffective in stimulating private capex. On the contrary, it will signal households and lenders to fuel exuberant retail lending again, something that RBI is working to control in view of the rising default risk. It will also discourage bank deposits when banks are scampering for them, hereby eroding the counter cyclical buffer of banks.
Hence, apart from boosting market sentiment, insistence on rate cuts at this juncture will be inconsistent with RBI’s objectives of price and financial stability.
Beyond the fickle headlines of strong growth, there is indeed a profusion of distress among households with respect to productive employment and real incomes, which is discouraging private capex. These deserve structural policy responses. Pushing cyclical tools like monetary easing and rate cuts instead will be like barking up the wrong tree. Compromising the regulatory autonomy of the central bank can be a source of financial instability and add to the burgeoning fiscal burden eventually.
The writer is is Co-Head of Equities & Head of Research - Strategy & Economics, Systematix Group. Views are personal