Constituent policy

What does the credit policy say about the future? writes Madan Sabnavis

The credit policy was a highly anticipated announcement as usual. While it was almost certain that the repo rate would be increased, there was speculation about the amount of the increase and the stance the MPC should take. And for the banks, there was some apprehension if there would be more action on the CRR.

The fact that the market reaction was gloomy is indicative of the fact that there were no major surprises as things unfolded as expected. The yield on ten-year bonds remained around 7.50%, and fell below this level, initially. What do you think of this policy?

The first is that the RBI has signaled that inflation will be our Achilles heel this year with three quarters above 6%. It also means that the repo rate will only go up, which is good for custodians but not good for borrowers. There have been indications that the RBI is set to withdraw the extraordinary accommodations that have been provided during the pandemic. This can therefore be interpreted as indicating that the repo rate will for sure return to 5.15%, which was the rate before the lock. And, of course, there are chances to be further increased, especially if the inflation rate will be above 6% until December. There are policies coming in August, October and December so it will be interesting to see how many more hikes there will be. A measured guess will be that it could rise at least 75 basis points.

The second is what happens to deposit rates? Normally deposit rates tend to increase with a lag and only new deposits would get the higher rates. Typically, the elasticity of deposit rates would be around 50%, meaning that if the repo rate increases by 100 basis points, deposit rates would need to increase by 50 basis points. However, the current situation is different because there is excess liquidity in the system and the banks do not need additional funds. Therefore, there will be more pronounced delays in raising deposit rates. There is no point in raising deposit rates and collecting funds that are invested in the SDF for 4.65%. The credit cycle should turn around.

Third, loan rates will react differently for customers. Since the introduction of the concept of external benchmarks, banks have linked loans to the repo rate or to a Gsec benchmark. Loans such as those on houses are tied to the repo rate. Here there will be a rapid transmission of higher interest rates to borrowers. In the case of MCLR however, the movement will be slow as it is based on a formula which also has deposit costs as a component. Therefore, MCLR-linked loans will experience less traction than repo-linked ones. In the event of lending tied to the government security rate, there will still be some breathing room as Treasuries and Gsec yields react at a slower rate as there is also central bank action underway which guarantees that there are no rate peaks. In addition, the RBI had assured in its policy that it would separately discuss how the government’s borrowing program would be conducted with minimum distortions.

Fourth, the RBI did not invoke a hike in CRR rates, which is a relief for the banks as such seizure of funds does not earn them any interest. The previous 50 basis point hike took out around Rs 80,000 crore, which even at the SDF rate of 4.65% would mean a loss of around Rs 3,700 crore.

Fifthly, the RBI has not changed its position on growth for the year which is expected to be 7.2%. That seems fair, because the first two months of the fiscal year have been good for the economy. GST collections continue on the fast track. The PMI indices for the manufacturing and services sectors are up. Exports are still buoyant and core sector data for April was surprisingly strong despite the high base effect. Consequently, the economy has shown resilience in the face of the war and its impact on the growth front.

Sixth, the RBI now has a forecast of an average of 6.7% for inflation. This is serious and worrying because continued inflation of 6.2% in FY21, 5.5% in FY22 and now 6.7% in FY23 would mean that the cost of living has increased by 18.4% in three years after a rather tumultuous journey with the pandemic and confinement affecting the economy quite significantly. This may hurt consumption this year as pent-up demand played its part in the third and fourth quarters of FY22 and would further dilute this quarter as households fill up on travel and vacations for the season.

Therefore, the future remains a bit uncertain and needs to be monitored politically. The center did its part on taxes to control inflation. But something more needs to be done if inflation is to be brought back to the 6% mark any time soon. The fiscal framework of the center and the states can be revisited.

(Madan Sabnavis is Chief Economist, Bank of Baroda, and author of Lockdown or Economic Destruction? Opinions expressed are personal)

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