In the previous policy resolution the members voted for easing interest rates by 25bps with a neutral stance sighting welcome drop in food and core inflation & lower economic growth. The major concern currently for government and RBI could be sagging economic growth having witnessed two major structural reforms; demonetization and GST.
Currently, economy is going through the shift in the way people save and spend and the way businesses comply for taxes. The much needed transition to one tax policy has however distorted the working capital cycle in short-term with businesses especially MSME/SMEs spending more time on compliances, pre-GST destocking etc. The reading on Q1 GDP at 5.7% makes the same point; the growth has dropped to seven-quarter lows with less encouraging job creation figures. Government hasrealised the need for some policy stimuli may be on fiscal front or through interest rates. The capacity utilisation at an industry level continues to at sub 75% mark, especially in infrastructure sector. The output gap and low utilisation levels might need a continuation of neutral to accommodative policy stance.
We believe MPC can afford to err on easing side rather wait for banks to aggressively transmit previous cuts. The easy liquidity condition and reduction in cost of liabilities will ensure competitive reduction in lending rates and hence better transmission. The real rates are high enough to take the judgment call of easing by 25-50bps in next 3-6months (if growth outcome continue to disappoint) as there will always be room to for some tactical tightening if inflation outcome sours.
The CPI inflation appears to have bottomed out at 1.5% and the recent reading before MPC is at 3.4% with Core-CPI at 4.5% (HRA impact related jump from 4%). Even though inflation has jumped by 100bps from lows the culprits were food inflation and one time HRA impact on core readings. The important message from inflation readings is that the price pressures are at much lower levels at 3-5% almost half the inflation experience in previous decade.
The real rates on expectation basis remains at all-time high levels between 2.5-3%, the nominal and real yields on Indian fixed income instruments remains one of the highest in the EM pack, attracting huge FII flows. INR has thus appreciated from $67 to $64 (however, the currency has deprecated recently to 65.5 after US Fed policy statement).
The CAD has widened to 2.4% from the lows of 1.5%, however the full year number is expected to remain closer to 2% comfortable mark. The comfort can be derived from healthy capital flows specially FDI. The RBIs Forex reserves stands at healthy $400bn.
Monetary stimuli will give some signal for reviving the animal spirits and thus restart the investment cycle (27% of GDP from the peak of 32%); current investments will ensure lower future inflation outcomes in future.
Kunal Shah is CFA, Fund Manager - Debt, Kotak Mahindra Old Mutual Life Insurance Limited