Third Bi Monthly Monetary Policy – To hold or Cut the Rates?

The Reserve Bank of India on August 4, 2015 will announce its Third Bi-Monthly monetary policy. As any other policy decision, this one seems to be tough as well. On one side, the GOI recommending a rate cut to make sure that earnings improve and on the other side are the global events that should be considered to make an appropriate decision. The question persists, will the RBI cut rates or will it prefer to hold the repo rates at the current levels and ask the Govt to take the lead in reforms. Let us understand what the various domestic macroeconomic indicators and the global events suggest. We will evaluate the CPI, WPI, IIP, Credit Growth, deposit growth, FII inflows, call money rates of liquidity, global data, and finally ERI (Equilibrium Real Interest being the most decisive factor)

Before we start with it, the following link will give you an idea as to what we predicted in the second bi-monthly monetary policy:

Second Bi-Monthly Policy

In the ongoing year from January 2015, Dr Rajan reduced the repo rate by 75 basis points in the past bi monthly policies. The rate cut was welcomed by the industries for the growth prospects involved, except the banking sector. Inflation targets were achieved with the accommodative policy so far. But the conditions of the second half in future looks to be more challenging for the RBI. Here’s a short recap how repo has been changed since the Rajan era.(Since Sept 4, 2013).

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The top 3 factors, CPI,WPI and IIP growth, have always been the key determining factors for the RBI to take a decision on the repo rate. CPI in the past month has slightly inched up from 5% to 5.4%. Although, it seems to be in the inflation targeting zone of under 6%, the monsoons will have their own share of contribution in the CPI numbers later this year. So far, the monsoons have been as per expectation apart from the first two weeks of July, where we saw 12% below average rainfall. The point to be focused on is that, food inflation has increased in the past month’s data. The core inflation (Non food Non fuel) inflation also headed north. It is also expected that the CPI might head north in the second half of the year because of subnormal monsoons and inefficient Public Distribution Systems. Based on the average CPI for the year, which is hovering very close to the 6% mark, it is important for the RBI to wait for the CPI to decrease further and reach a sustained under 6% level. Right now, it looks likes the Jan 2016 inflation target of under 6% CPI is in doubts. WPI, on the other hand continues to be in the dis-inflationary zone. WPI data indicates that inflation has slightly risen up to -2.4% from -2.36%.

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Although, It is evident from the CPI, WPI and the GDP deflator figures that the inflation has eased compared to previous years, the rest half of 2015-16 looks tricky.

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Finally, it also depends upon how the rainfalls fare in the coming months and how does the Govt handle the supply side problems effectively. The interesting thing to watch out for will be IMD forecast v/s Skymet forecast. IIP has slipped to the levels of 2.7% which is quiet disappointing for the markets since it’s an indication of manufacturing output slowdown and subsequently subdued demand as well. Today, the core sectors growth numbers for June declined from 4.4% to 3%. Core sectors (8 of them) hold 38% weightage in the calculation of IIP, which suggests that the IPP might have further downside risk. The Q1 numbers of most companies have not been great, except the private banks. . The markets are hoping that RBI with the Govt might cut rates to boost growth. But, we suspect that they are hoping for the reforms to kick in (GST and Land Bill) instead of a rate cut, in the form of a catalyst.

On the banking front, the deposit growth has been outpacing the credit growth from past few months. Credit growth is at a 17 year low of 9.52%. The NIM and NII are already under some downward pressure because of the consecutive rate cuts. Further reduction of repo rate might drive the credit cycle but will definitely hurt the profitability of banks in the near future, which RBI would like to avoid. FIIs however have been steady in the past month. We witnessed slowdown in the FII inflows in the April- June quarter so far, thus weakening the rupee. Outflows were seen because of weak annual earnings by the corporates and the reforms not getting a green flag in Rajya-Sabha . The issue of P notes recently had triggered an outflow, although the fears were cleared up by the FinMin last week. The volatility index has been hovering around comfortable levels of 16% showing signs of lower volatility in the short-term. The overall liquidity position in the country is in surplus at the moment. With call money rates persisting well below the repo rate and the surplus in the system being mopped up by RBI worth Rs. 8700 Crores via the bond auction route, RBI seems to be in a mood of keeping the tightening stance for a while.

US Fed in its FOMC meet recently announced that the employment and production data has been promising. They have signaled of a rate hike soon, but soon does not seem to be September. We are definitely looking at a rate hike this fiscal by US Fed. Greece Debt crisis although could not have a dent on the rupee lately. China has seen its worst downfall in the past 8 years with its Shanghai index tanking in the most unnatural ways. Crude oil prices are having continuous downward pressure. To facilitate the stability of rupee, RBI might want to wait for the right time for any further cuts.

There is one more problem the country is facing, which is ineffective “Monetary transmission”. The RBI reduced the repo by 75 bps but the banks reduced their base rates by only 30 bps. Banks could not pass on the rate cut to the same extent because of the fear of stressed profitability. In such weak monetary transmission stage, the efforts of revival of economy through monetary measures might not help. From all the data and current state of the economy, Dr. Rajan might want to hold the rates until next notice.

Lets now focus on the most important factor, which is Effective Real Interest rates(ERI). ERI is the rate which is considered acceptable by the central bankers over and above the inflation levels which is right for the economy to grow. RBI considers, average ERI currently apt for the economy is 1.75% over the inflationary levels. With the inflation slightly inching up, as per the ERI calculations, the repo must be slightly more than 7.25 (should be about 7.4-7.5%). But, a rate hike can have some serious consequences on the economy which is looking at a sustained growth rate in the future.

The growth is henceforth more dependent on how the NDA govt rolls out its key reforms of GST and Land Bill. The RBI, witnessing the present conditions, has done extremely well in delivering the dual objective of inflation control and growth. However, after analyzing all the factors, both magnitude and directional in nature, we predict that RBI might choose to hold rates at the current levels of 7.25% in the third Bi-monthly monetary policy. CRR and SLR ratios are unlikely to be changed as the liquidity conditions are surplus. Readers need to be aware of the fact, that RBI is looking for reduction in the two ratios in the future to their minimum levels, which are 3% and 15% respectively. Reduction in those can only be made when there is either high demand for liquidity or a liquidity crunch in the system. Although, if not on 4th of August, we might see some action from the RBI in late September in the form of an “Out of the Policy Cycle” review. Going forward, the rainfall and the outcomes of the ongoing monsoon parliament sessions will decide the direction of growth as well as the financial markets. To sum up, with the next US Fed policy in Sept having more probability of a rate hike, RBI in this policy review might just choose the Wait-N-Watch approach.  

Thank you. 🙂

Dashing Denmark – A Case of Extraordinary Monetary Easing

An unusual way of monetary easing has become a favorite solution of most central bankers in the recent past. Lets take a look at the meaning of the word monetary easing before we discuss on those lines. Monetary Easing can be defined as an “Action by a central bank to reduce interest rates and boost money supply as a means to stimulate economic activity”. Precisely putting it, the actions taken by the RBI in the past few bi monthly meetings can be referred to as monetary easing.However, monetary easing can be bifurcated further into the ordinary(rate cut) based on macro economic indicators and the other being the unusual monetary easing used in adverse situations to get the economy moving. Few examples of unusual monetary easing can be US Quantitative Easing, Japan’s QE(Quantivative Easing) to revive their deflationary scenario and the most recent one being the ECB (European Central Bank) starting the Euro QE to revive its economy which will continue at least till Sept 2015.The move by the US Fed, ECB and Bank of Japan seems to be very similar and been done for very similar reasons but what they missed was the currencies they were dealing with were completely distinct, in value terms.

The best way of easing the monetary policy can be a rate cut. It was most certainly ruled out since Japan, US(0.25%) and Euro zone(0.05%) were all witnessing near zero interest rates from a long time. The measures taken by the above mentioned central banks were thus in the form of printing and putting in more cash in the system to revive the economy since all of them were out of options. But Denmark, decided not to go for QE at the time of slowdown ( although interest were near zero) but instead go for further rate cuts, making it an extraordinary monetary easing scenario.

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This move created a problem in the economy instead of boosting growth. So what exactly did the Danish central bank do ? In January, looking at the economic slowdown, the Danish central bank decided to cut rates( which were already hovering near 0%). The central bank, instead of going for a QE, went in for 4 consecutive rate cuts since January thus leading to an interest rate of -0.75% which ultimately brought the bank deposit rates into the negative rate zone. On the other hand, the Govt of Denmark was paying the corporate companies an interest of 1% for advanced tax payments and prepaid tax payments if any. This made the bank deposits less attractive as compared to the tax payments. Companies usually enlist legions of lawyers and even move headquarters to minimize tax payments. In Denmark, they could be better off overpaying them. The companies started holding immense amount of money with the tax authorities since they were paying 1% on their advance payments. This started costing the Govt as well as leading to dilution of transmission effects of the monetary policy. The banks on the other hand were charging their corporate customers to hold cash in banks. This has led to a disastrous situation where the money is being moved out of the real economy which is supposed to be the other way round.

It created high costs for bank because of the low-interest rates in terms of lending business. The loan became cheap and the prices of the real estate started shooting up. All this can be related to the Gold monetization happening in India. If we are struggling to get the already existing gold reserves to the banking system, just imagine what can be the condition if money moving out of real economy is to be brought back in. Customers or general public on the other hand in Denmark are facing what people in India holding gold jewelry have been facing. A person holds gold with the bank on which they wont pay interest but instead take locker charges from them for keeping those safe. In the same context, Denmark citizens are facing similar problems on the cash side of it which is making them move away from the bank deposits. The customers are feeling like the following images in Denmark:

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NIRP

Entire situation has created immense problems for Denmark including the revival, the rising real estate prices, banks taking a hit on their profits and money moving out of the real economy. Although Denmark Govt has taken charge of the situation and are trying to come up with various legislations to make sure the economy can be insulated from these unexpected effects of monetary easing.

To sum up, such actions if continued by various central bankers, will result into tremendous decline in the global growth rate. The economic slowdown in the world, where the world economy is growing by mere 3-4%, is because of the attempt of the monetary policy to be made in such a way that it affects the world instead of having effects. Dr Rajan in his recent press conference gave an immensely important statement,

 ” The world economy can grow in a sustained manner only if the monetary policy of each country is designed with a view of facilitating trade in the entire world economy rather than with a mindset of affecting the various economies because of the mere reason of inter-dependencies”

The conclusion being that each country is different in its various aspects of the economy, which should be respected and the Central bank should work in tandem with the policies of the Central Govt and vice versa. Every Central Banker and the Govt should take lessons from this event that none of the two institutions can run without appropriate guidance from each other. Denmark was a case of non accommodative policy execution more than an extraordinary monetary easing. 

Thank you 🙂