RBI’s outlook on inflation and economic growth will provide the cues on the future interest rate trajectory. In this respect, India’s wholesale price index during June fell at an annual rate of 2.4%, the eighth consecutive monthly decline. The contraction is clearly due to softness in oil prices.
Meanwhile the central bank is comforted by healthy foreign exchange reserves and sharp descent in crude oil prices. Lower oil prices have provided much needed relief to the country’s current account balance, wherein India imports majority of its energy needs. On growth numbers, output of India’s core eight infrastructure sectors grew 4.4% in May, the highest growth rate in six months. The core sectors grew 3.8% during May 2014. This is a much better improvement when compared with the declines in March and April. The recovery is attributed to the surge in the production of coal and refinery products. Meanwhile, India’s industrial production grew 2.7% in May 2015, slower than the growth of 3.4% in April. The slowdown has been attributed to sharp decline in capital goods and consumer goods numbers. The softness in Industrial output numbers was seen in spite of better-than-expected core sector output. In recent times, IIP number has been largely inconsistent.
The central bank will also keep a tab on the cues emanating from US Federal Reserve. Janet Yellen has reiterated on several occasions that an interest rate hike this year is on the cards. Yellen has justified her view by stating that the labour market is moving evidently closer to normalcy. The latest FOMC policy statement also conveyed that US economy and the labour markets continue to strengthen. It seems that Fed is gradually reaching its goal, manifested by decent job gains and dip in unemployment rate. With the next FOMC meeting in September, the consensus calls for a 25 basis points rise in the interest rates. Effectively, there are concerns that a Fed rate hike will dampen the investment flows in the emerging markets. However, we infer that the economy will be able to withstand the repercussions, thanks to wide interest rate differentials between the developed zone and India. In addition, the Indian government is initiating moves to simplify the process to invest in India. The government has approved a policy for composite foreign investment in India. Foreign Direct Investment, Foreign Institutional Investors and other investment routes will be included under one category.
On domestic liquidity management, Reserve Bank of India is surprisingly initiating measures to suck the excess liquidity from the banking system. RBI had announced open market sale of government securities. Of late, the central bank is selling big quantity of shorter-maturity bonds. As a result, India’s sovereign bond yields have remained sticky post June rate cut. In fact, there has been considerable volatility in the G-Sec markets, with yields on the new 10-year benchmark 7.72 G-Sec 2015 surging to 7.91%, while yields for 8.4 G-Sec 2024 touched 8.10% in June. However, the yields later moderated after RBI cancelled weekly Government auction of few papers. Yields on the new 10-year benchmark 7.72 G-Sec 2015 are now trading around 7.80%, while yields for 8.4 G-Sec 2024 are around 7.96%. There is also a perception that RBI might initiate further liquidity tightening steps as the central bank wants call money rates to be on par with the repo rate. On various occasions, call money rates have moved well below the 7% level, indicating surplus liquidity. To counter this, the central bank will keep on conducting open market sale of government bonds.
On outlook, subdued economic growth characterized by mixed corporate earnings and uninspiring macroeconomic indicators compelled the central bank to cut interest rates in June. Real demand has not picked up yet; and the economic growth is still below potential. There has been a downward revision to Gross value added estimates for FY2014-15, while the projection for output growth for 2015-16 has been marked down to 7.6% from the previous estimate of 7.8%. Although the incumbent regime has initiated measures to unclog the investment pipeline, the ground reality is not inspiring. Economic activity is conveying mixed signals, with expansion witnessed in core sectors like coal production, while exports, automobile sales and stressed banking sector are exhibiting a dull picture.
In addition, the government’s inability to pass important economic reforms has dampened the prospect of a strong recovery in growth. There is a lot of disappointment on the deadlock in the parliament, wherein the opposition is thwarting any meaningful discussion on land acquisition bill and Goods and Services Tax bill. There is a strong perception that nothing will materialise on land acquisition and there is lot of uncertainty regarding the plans to convert the country into one tax zone. The mentioned bills need to be passed in the upper house of the parliament, where the regime lacks the needed majority. The government seems to be facing lot of impediments in providing an impetus to growth. Economic reform is the only panacea; unfortunately it still looks out of reach.
Slower growth and tamed inflation may persuade the central bank to go for one more rate cut during the end of this calendar year. Inflationary concerns have mitigated once again after a scare over the unprecedented lull in the monsoon during first half of July. In spite of the recent rise in food prices, CPI inflation remains contained within the RBI threshold of 6%. Lesser than expected monsoon deficit, better food management policy, decline in prices of industrial commodities and relatively resilient Indian rupee will provide the courage to RBI to act on the rates. A rate cut during October-December period can be followed by subsequent rate cut at the fag-end of the fiscal year.
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