Rajeev Malik: Don't rush to cut policy rates

The Reserve Bank of India should stay firm on policy rates, though the time is right to signal a decline in premium on liquidity.

The upcoming mid-term review of the RBI's 2007-08 annual policy promises to be another interesting meeting, with a variety of views""some surprisingly conflicting"" being expressed by politicians, local banks, public and private sector economists, and some analyst-types. Differences of opinion are nothing new and occur in other countries as well. But the macroeconomic situation India finds itself in is more challenging that what is being experienced by other economies. Additionally, excessive local media reporting of the views of different stakeholders, with each looking after personal interest rather than the well being of the economy, only adds more noise than signal.

The outcome of the upcoming policy can be thought of as the interaction between three key factors: (1) growth outlook, especially the characterisation of the magnitude and scope of the current slowdown; (2) inflation expectations; and (3) the importance accorded to liquidity management. The global economic backdrop is always important, though the RBI will have greater focus on domestic issues. Importantly, financial markets have scaled back the expectations of another rate cut by the Federal Open Market Committee (FOMC) at the end of this month.

The RBI will probably maintain GDP growth forecast of around 8.5 per cent over a year ago for the current fiscal year, down from an estimated 9.4 per cent in the prior year. It is important to understand the nature of the current slowdown. Firstly, monetary tightening will at best only moderate, not derail, growth. Secondly, the slowdown so far is not pronounced or even widespread. Thirdly, investment spending remains on a roll, with the investment-to-GDP ratio likely to climb higher, but understandably at a slower but more sustainable pace.

Fourthly, the pace of infrastructure spending will remain an important growth driver. Fifthly, even at the current slower pace, bank lending is growing faster than nominal GDP growth, a fact that should force growth pessimists to cover their heads with paper bags. And finally, recent rupee appreciation will hit exports of some goods and services, though the impact will likely be more pronounced on employment in some labour-intensive industries than on economic growth.

The most recent quarterly results do not offer any indication of a sharp slowdown. Essentially, the current moderation is still confined to a few sectors. Further, the latest industrial production data for August should dispels worries about an exaggerated slowdown.

Headline WPI inflation continues to be well below the RBI's comfort level of 5 per cent over a year ago. The cumulative impact of monetary tightening has checked inflation expectations. Higher rates have also caused a desirable and much needed moderation in the pace of credit expansion.

A hike in the prices of petrol and diesel appears unlikely owing to political compulsions. Further, imports of some food items and improved farm output following the decent monsoon season rainfall will likely check food inflation. The bottom line is that WPI inflation will likely remain below the RBI's comfort level for the remainder of the current fiscal year.

Comments from some local bankers about the need for a cut in policy rates are puzzling, as banks themselves have not lowered their rates meaningfully, despite the significant improvement in liquidity conditions and the recent decline in the banking system's loan-deposit ratio. Talk of "uncertainty premium" keeping rates high is just not convincing.

The RBI will probably indicate in the policy statement that premium on liquidity has declined owing to the fall in WPI inflation and loan growth, and the slight softening in economic activity. However, it will likely adopt a wait-and-see approach on policy interest rates.

The message of lower premium on liquidity will be an important signal, and should prompt banks to lower lending and deposit rates. The last thing the RBI needs to do is to cut policy rates only to have to deal with a pickup in loan growth and inflation that re-ignites worries that could prompt it to quickly reverse course. Such a reaction could also generate more political heat for the government.

The more favourable policy rate differential will increase the attractiveness of rupee assets, but the RBI has to focus more on domestic factors, rather than rush into cutting rates. Further, the surge in capital inflows in the last few months is largely dominated by equity portfolio inflows rather than inflows attracted by the rate differential. Sebi's proposed restrictions on participatory notes (PNs) will surely affect the magnitude of portfolio inflows.

Admittedly, delay in adjusting policy rates will keep up the appreciation pressure on the rupee, but the correct course of action is to maintain policy rates appropriate for domestic conditions, and allow further rupee appreciation. This is what the RBI seems to be following, though it is still intervening aggressively. Essentially, the central bank has been only managing the move lower in $/Rupee, though it'll now get some breathing room following the restrictions on PNs.

Liquidity management will continue to be challenging for the RBI. However, the central bank does not need to maintain the same premium on liquidity as before. The RBI has not signalled this verbally, but for all practical purposes, the reverse repo is the current operational rate, as the overnight rate has settled at that rate owing to easy liquidity conditions. This is in contrast to the repo rate being the key operational rate a few months ago. Back then, the RBI hiked the repo rate but kept the reverse repo unchanged, thereby widening the width of the interest rate corridor.

However, now there is scope for narrowing the width of the policy rate corridor, but the adjustment via lower repo rate will probably begin in the first quarter of 2008. This is because there will be more concrete evidence about the pace and nature of the ongoing moderation in economic activity.

Local banks are hoping for a signal from the RBI that the CRR will not be hiked in future. A CRR hike appears unlikely on the 30th following Sebi's proposed measures. Perhaps the measures are meant to check capital inflows so as to diminish the need for an imminent CRR hike to check excess liquidity, which in turn will allow banks to cut rates. Unfortunately, the RBI cannot give an assurance of no more CRR hikes, especially if capital inflows do not ease meaningfully.

Banks were caught off-guard earlier in the cycle when they expanded their balance sheets at a torrid pace. Now they appear to be caught in a bind owing to the moderation in the pace of lending, especially to the retail sector, but there is a preference for keeping deposit rates high. Essentially, banks have to sort out their own asset-liability management issues, and should not look to the RBI for all the solutions to their own problems.

The author is Executive Director at JPMorgan Chase Bank, Singapore. The views expressed are personal