Market pulse for 21 June 2012: Moses

RBI struck between stake holders’ expectations and Governments’ policy inaction

It is the first time the market has seen such a strong defence of monetary actions by the Governor. At the outset, RBI is indeed not in an enviable position during these crisis days to deliver expectations from the stake holders without minimum support from the Government. It becomes worse when the external sector turns excessively adverse exerting strong headwinds diluting the impact of monetary actions. This time, Industry and financial markets expected 50 bps CRR cut based on spike in drawdown from LAF counter to over Rs.1.25 Trillion on run into policy day. This was seen to be extremely high as against RBI’s tolerance level of 1% of NDTL (around Rs.60K Crores). There was also precedence of delivering 75 bps CRR cut ahead of policy day when drawdown from LAF counter exceeded Rs.1.5 Trillion. Although RBI prefers OMO for liquidity injection, it is liquidity neutral to cover week-on-week bond supplies from RBI. The major beneficiary of OMOs is the Government, to keep cost of borrowing at administered affordable rate.

The expectation of 50 bps CRR cut obviously did not have linkage to any economic data. Moreover, current CRR of 4.75% is seen to be at higher end of 3.0-6.0% band with room for downward revision. The industry also expected 25-50 bps rate cut based on downtrend in core inflation print below 5%, weak IIP data of near zero percent growth and shocker from Q4FY12 GDP growth of 5.3%, and considered downside risks to growth is more severe than upside risks to inflation. This being the base numbers for FY13, it is seen as impossible for the Government to achieve the set ambitious targets for FY13. It is also seen that MM Sovereign yield curve is inefficient with 1Y yield below 10Y yield, thus not building the time value, with the need to build steepness in the curve by guiding the 1Y yield down. There are no signals to look for sharp reversal in interest rates to validate the inversion in the yield curve. There is no significant impact on MM rate curve since delivery of 50 bps rate cut in April because of elevated overnight rate at higher end of LAF corridor. It also looks difficult at this stage to shift system liquidity from deficit to surplus to get the benefit from shift of operative policy rate from Repo to Reverse Repo rate. The combination of these factors built strong expectation of 25-50 bps rate cut by the Industry and entire financial market participants. Moreover, current operative policy rate at 8% is seen to be trading at higher end of 4.0-9.0% acceptable band with good room for downward revision. Therefore, it is fair to conclude that the expectation from the Industry and financial market participants was genuine, thus the post-policy disappointment!  

What went wrong? The issue is between the Government and the RBI. It is true that RBI cannot shift into dovish monetary policy stance when headline inflation is at elevated levels. There seems to be no resolutions to many critical factors. The common man is concerned about high food price inflation. While this cannot be controlled from demand side, there is little action from the Government to address from supply side and through administrative efficiency. It is less said the better on fuel price inflation as it stays administered with high subsidy content. The food and fuel price inflation print will move up on roll-out of minimum support price on agriculture commodities and price hike in diesel, kerosene and cooking gas.

The other major concerns of RBI which have direct relevance to monetary system are from fiscal deficit and Balance of Payment. The impact of these is felt on rupee liquidity, flight of rupee capital, exchange rate instability and upward pressure on interest rates. It is impossible for RBI to control inflation with high fiscal deficit and weak rupee. RBI wants to see tangible actions in pass-through of subsidy cost; measures to bridge Current Account deficit and reforms to attract sustainable long term flows into Capital account. It is believed that unless these structural issues are resolved, shift into dovish monetary stance may not be effective to support growth.

What next? The resolution to this growth-inflation conflict obviously is in the hands of the Government. It will be a long-drawn process but the first step needs to be taken quickly with political consensus. It is not that the Government is not aware of these critical needs; the issue is in its execution capability (and/or limitation) to bring the coalition partners together. There is no guarantee that parties outside UPA will extend support to Government on these agenda. The fragmented political mandate is seen as the curse for the Indian economy; Government is unable to bite the bullet on fear of opposition from other political parties or has deep pockets to absorb costs. It is crisis time and it is essential for the Congress Party to manage support within and outside UPA to roll-out next generation reforms to attract off-shore liquidity and capital and get into the act of fiscal consolidation.

The economy runs the risk of sovereign rating downgrade to junk status by global rating agencies. We may not accept it but lenders and investors will take note of it and move away from the storm. It will be catastrophic on asset markets; weak rupee, high bond yields and weak equity market will kill the investor confidence on the Indian economy. The concerns from the rating agencies are on political governance, fiscal consolidation, growth, inflation, balance of payment, exchange rate stability and so on. The Governor can rest assured that the Industry and financial markets will be with RBI to exert “pressure” on the Government to get their acts right to get the economy back on track.     

What is the take-away? It is possible that RBI will be into an extended pause mode. The headline inflation (wholesale and retail) will stay high and inflation adjusted borrowing cost will be low, not considered as major risk to growth. There will be added pressure from external sector as FED/ECB/BOE starts roll-out of next round of stimulus measures, seen as inflationary for India. There is lot to do for the new FM to bridge gap between expectations from RBI and execution capabilities of the UPA. The other stake holders of the economy have no option but to wait and hope for the best!