The Monetary Policy Committee of the Reserve Bank of India (RBI) has increased the repo rate by 90 basis points (bps) so far in 2022 and we expect a further increase of 75bps in this fiscal. The withdrawal of surplus liquidity, which began gradually last August, has gained momentum recently. The flight of foreign capital from asset markets has also tightened domestic financial conditions. Continuing rate hikes amid high inflation, uncertainty and tighter monetary conditions globally, and further flights to safety suggest that the financial situation in India can only get dire from here on out.
Tough conditions were expected in 2022, as central banks, including the RBI, dialed back easy-money policies. The shock waves of the Russia-Ukraine conflict in response to rising inflation accelerated this process.
CRISIL’s Financial Situation Index (FCI), which tracks momentum in the equity, debt, money and foreign exchange markets, as well as the policy and lending position, reflects the consistent strengthening of overall financial conditions in India in recent months. The important question is, will this harm the green shoots of growth?
Three years after the fall in interest rates, our economy is facing an increase in the cost of borrowing. Most people miss the 115bps reduction in the policy repo rate announced by the RBI to prop up the economy during the pandemic. But monetary policy easing began in February 2019 – long before the pandemic hit – and rates were slashed, given low inflation and the need to support growth.
Between February 2019 and May 2020, the repo rate saw a cumulative reduction of 250bps from a high of 6.5%; RBI also pumped in liquidity between March 2020 and July 2021 to ease the availability of funds during the pandemic. Extra Liquidity Average 4.7 trillion every month during that period and helped bring down short-term interest rates by 140-180bps compared to pre-pandemic levels.
A lot has changed since then. Growth is slowly recovering and the rise in inflation has necessitated monetary policy action. Compared to a year ago, short-term interest rates in the money market are now 80-200 bps higher, while 10-year government bond yields are on average 135 bps higher, due to RBI actions and higher government borrowings. An increase in the cost of borrowing is the last thing an economy would want in a scenario of weak growth. But it’s playing the same thing. Globally, rising borrowing costs are expected to slow growth in the coming quarters. For example, in the US, the Federal Reserve’s strict cycle foreshadows a recession. Growth prospects are bleak. In India, however, higher interest rates may play a less significant role in influencing domestic demand and economic growth this financial year.
For one, rising interest rates affect the US economy more than India, given the former’s greater reliance on credit (home loans account for about 216 of GDP for the US, compared to about 55% for India). % Is). In India, there will be some impact on highly interest-rate sensitive sectors, but the overall impact on the economy will come with a lag of a few quarters and should be relatively minimal. We expect the RBI to carry forward its rate hikes in 2022-23. Thus their peak impact can be seen towards the end of this financial year and the next.
Second, although interest rates in India are rising, they are below pre-pandemic levels for many instruments (including repo and bank lending rates), while credit availability remains comfortable. Even after the expected trajectory of rate growth for 2022-23, the repo rate at 5.65% will be much lower than the previous peak of 6.5% seen in 2018. Conversely, the US is likely to see larger increases. S&P Global expects the fed funds rate to rise to 3-3.25% in 2023, up from the 1.5-1.75% level in February 2020 and the highest since the beginning of 2008. Lending rates in the US are already trending upward and hurting growth. , While banks in India are also charging higher fees, their rates remain low relative to pre-Covid levels as well as over the past decade.
Third, the ‘real repo rate’ (minus inflation) has been negative for more than two years, indicating relatively easier monetary conditions. RBI’s rate hike will reduce the negative gap with inflation by the end of 2022-23. The 2013 RBI paper shows that real rates affect growth.
Lastly, another factor that differentiates India from the US is that while cost of funds is rising, supply has not yet been constrained. Bank credit growth is on the rise, driven by improving demand, and reached its December 2019 level in April.
Crisil’s FCI shows that conditions are gradually getting tougher from November 2021 onwards. External headwinds are expected to strengthen in the coming months as major central banks hike rates to tackle inflation. Net-net, the conditions are expected to move beyond the dream run witnessed in the last two-three years.
Nevertheless, overall financial conditions are not quite as tight as in the past decade. They are also not expected to tighten to the extent that creates headwinds for growth. While segments such as currency and bond markets, which benefited more from pandemic policy easing, may feel a greater pinch as easier liquidity is withdrawn, negative real interest rates and improved credit offtake will be supported.
Other factors, such as rising inflation and slowing global growth, could pose major constraints to domestic growth this fiscal.
These are the personal views of the authors.
Deepti Deshpande and Pankhuri Tandon, respectively, are the Principal Economist and Economist at CRISIL Limited.