We expect the RBI’s Monetary Policy Committee (MPC) to hike policy rates by 25 basis points (bps) on June 8 to tackle inflation and offset Fed hikes. It should also shift the monetary policy stance from moderate to neutral as Governor Das is already prioritizing inflation over growth. Looking ahead, the MPC should increase the repo rate by another 75 bps by April 2023. Second, we expect it to increase the HTM limit of banks by 1% and extend the higher HTM limit till FY26. Lastly, RBI will increase the FCNRB deposit rate cap on LIBOR by 50 bps to attract NRI deposit inflows to augment foreign exchange reserves.
RBI MPC should hike repo rate by 25bps on June 8, August, October and April. This will take the terminal repo rate to 5.4%, which will take India’s growth rate closer to the maximum inflation range of 5.5-6%. While we were averse to the April policy call for a hike in rates, we are 50 bps below the consensus this time around. As RBI has already hiked policy rates by 80 bps since April, we expect this to ease the pace of tightening given the shallow recovery. This will likely reduce FY23 real GDP growth forecast by 20bps to 7%. We see real GDP growth at 6.7% in FY 2013 and 5.5% in FY14 due to domestic demand problems and the Fed-led slowdown overseas. We estimate that a US recession costs 100 bps to India’s GDP.
This begs the question, why do we now prefer the slow pace of RBI rate hikes over the road? Lending rates on bank priority sector loans to micro and small industries (MSIs) have now been linked to the policy rate. This was originally done to sharply cut down on their borrowing costs. A hike in the repo rate now will paradoxically hurt the first MSI. That is why we expect the Finance Ministry to offer subvention on bank loans to MSIs at a nominal financing cost of 1%. 130bn/$1.7bn (0.05% of GDP in FY 23-24). Since monetary policy affects inflation with a lag, it is unlikely that a 50 bps RBI rate hike will act any faster than a 25 bps hike in two consecutive policy meetings.
That said, we emphasize that the RBI MPC cannot continue to drive large negative real rates for much longer without raising future inflation. True, we see inflation at 7% in May and 6.3% for FY13, up from 7.8% in April. Yet, this is not only above the RBI’s 2-6% inflation target, but also higher than the threshold inflation. RBI MPC will likely increase its FY23 inflation forecast by 80bps to 6.5%.
A big relief is that the fundamental factors driving inflation are still quite benign. A shallow recovery restricts pricing power. Second, a good monsoon (103% of the general forecast by India Weather) should reduce inflation. Third, the hike in the RBI’s cash reserve ratio (CRR) has held back money (M3) growth (9.5% versus 11.1% a year ago). Fourth, the government’s recent excise duty cut (Petrol By.) 8/Litre and by Diesel 6/litre) and other measures reduce the pressure of rising commodity prices. Fifth, the Fed tightening should also quell commodity price inflation. Lastly, higher foreign exchange reserves are supporting the rupee to mitigate the risk of ‘imported’ inflation.
There will also be a push by the Fed to tighten the RBI further. We expect another 175 bps increase in 2022. Anyway, the gap between the RBI’s repo rate and the fed funds rate, at 365 bps, has fallen below the medium-term 500 bps average. While we do not consider it necessary to widen the gap given the high FX reserve, it is certainly not possible to compress it below the terminal 240 bps difference we project. We see trading in INR FPI outflow on a stronger US dollar due to unfavorable trading seasonality, Fed tightening and higher oil prices now at 77/USD level. As these factors reverse, it should appreciate back 76/USD till March.
The 10-year government bond yield should peak at 7.75% by March 2023 on the RBI’s tightening and higher fiscal deficit. The relief is that the RBI’s foreign exchange sales ($58 billion in our estimate) and the hike in CRR will expand the RBI’s ability to buy gilts in open market operations.
The author is Head of India Research, CLSA. Thoughts are personal.