By Invitation. Why the RBI may not cut rates

Will a favourable monsoon lead to more rate cuts by the Reserve Bank of India (RBI) in the remainder of 2016-17? This is the key question for the markets after the RBI’s status quo decision on June 7.

To answer that, there are a few factors one must consider. The monsoon, a main worry, is likely to have a salutary impact on food inflation in the second half of this fiscal.

The effect is likely to be more pronounced on crops such as pulses that have less irrigation coverage and higher sensitivity to monsoons — less than 20 per cent of the area used for pulse cultivation has irrigation facilities, compared with 90 per cent for wheat and 60 per cent for rice.

Indeed, if food inflation cools on a normal monsoon, headline inflation could slow by more than 100bps in the second half of FY17 relative to the first half. April inflation stood at 5.4 per cent and May CPI may come in at 5.9 per cent.

However, the tricky part is that the above numbers assume ‘ceteris paribus’ (other things remaining constant). This rarely holds true in reality.

This is why we do not expect any further rate cuts in FY17. The disinflationary pressures created by lower food prices in H2 are not likely to offset the rise in core inflation enough to allow the RBI to significantly undershoot its 5 per cent CPI target by March 2017. This is based on the belief that crude oil prices are likely to increase by 33 per cent to $60 per barrel in FY17, from $45 per barrel in FY16.

On top of this, increased economic activity on a better monsoon and the proposed 20 per cent pay raise for public-sector workers (after excluding housing rental allowances) is likely to increase demand pressures. Core inflation (excluding petrol and diesel inflation) has been sticky in the 5-5.4 per cent range for the last 18 months and further uptick in this segment is likely to absorb the bulk of the buffer created by lower food prices.

The impending final decision on size and timing of the pay revisions has also left an air of uncertainty around the H2 core — and thus headline — CPI trajectory. Therefore, unless oil prices decline or food prices fall faster than expected, further room for rate cuts is limited.

If oil prices stabilise at current levels of $45 per barrel, this may create room for a further 25bps of easing in FY17.

However, it still leaves the broader conclusion intact, namely that we are close to the end of easing cycle. In a matter of just another six months, the RBI’s comfort threshold for CPI inflation will be trimmed to 4 per cent from 5 per cent.

Fresh disinflationary pressures (either on a normal monsoon or tailwinds from global commodity prices) that could push CPI inflation towards the more ambitious 4 per cent target look elusive. Easing of supply bottlenecks could help but that’s likely to take some years rather than a few months.

Thus, the RBI’s emphasis on improving transmission by better liquidity management and addressing the issue of stressed assets in the banking sector becomes more important.

Work is already in progress on both these issues. And policy guidance on June 7 reassured of more measures if needed to facilitate transmission.

Here, the RBI’s reiteration of its commitment to address any temporary, but genuine, dollar or rupee liquidity shortage during the redemption of foreign-currency non-resident (FCNR) deposits was critical. In 2013, the RBI raised $26 billion (₹1.7 trillion) via the concessional swap scheme in the three-year maturity bucket to boost forex reserves.

While the RBI entered into forward purchases to minimise the impact of these outflows upon maturity (that is, in 2016), there are concerns of a dollar shortage if exporters cancel or roll-over the committed dollar delivery.

In such an event, the RBI might have to draw down forex reserves to partially meet the redemptions. This could also temporarily mop up rupee liquidity from the banking system, reversing the narrowing trend of liquidity deficit since April 2016.

So, while a favourable monsoon will help reduce inflation, this is not the sole consideration in the RBI’s policy deliberations. Offsetting factors such as oil prices and the effective transmission of policy will also be taken into account.

The writer is Head, South Asia Economic Research (India), Standard Chartered Bank