 "<b> Statsguru:</b> RBI's interest rate dilemma")
On December 7, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will be meeting for the first time since the decision to demonetise. Prior to the decision, analysts had expected RBI to cut rate, given the moderation in inflation and that investment activity had continued to remain subdued.
As Chart 1 shows, the Index of Industrial Production (IIP) grew by 0.7% in September after contracting 0.7% the month before. Within IIP, the capital goods segment, a proxy for investment demand, continues to contract at alarming pace. And, as Chart 2 shows, gross fixed capital formation has contracted for three consecutive quarters, with the pace of contraction actually accelerating. But after November 8, much has changed. For one, expectations of stronger US growth have led to the dollar strengthening and US yields rising. With strong job numbers, many expect the US Federal Reserve to raise rates in December.
But in India, with the banking system flush with liquidity, the 10-year G-Sec yield has dropped sharply, narrowing the interest differential between the US and India’s rates, as shown in Chart 3. This would have consequences for capital flows and the rupee, which RBI would have to factor in. As Chart 4 shows, foreign institutional investors (FIIs) have already withdrawn roughly $5.5 billion for equity and debt investments in November. The rupee has also weakened during this period as shown in Chart 5. Though this could be driven by both external and internal factors, the decline does seem to be in line with the fall in other currencies against the dollar. A further narrowing of the interest rate differential between the US and India could see further fund outflows, especially from the debt segment, which could put pressure on the rupee.
But on the other hand, RBI would also be mindful that economic activity is also likely to have been disrupted after demonetisation. This would impact GDP growth, though the extent is debatable. Sales growth of the BSE 100 companies, excluding banks and finance, which had rebounded in the second quarter to 3.6% as Chart 6 shows, is expected to be hit in the third and fourth quarters. This fear has prompted many analysts to call for RBI to desist from mild tinkering and drastically cut rates.