Premature easing by RBI may aggravate problems: Chetan Ahya

Though the market is eagerly waiting for a 50 basis points (bps) rate cut after the weak April industry output, Chetan Ahya, Managing Director, Morgan Stanley holds a completely different opinion. He warns that premature easing by RBI may aggravate current problems.

In an interview to CNBC-TV18, he explains if the RBI cuts CRR and injects a lot of liquidity through OMOs there will be a transmission into lower borrowing costs in the system. "It would not be sustainable because the gap between credit growth and deposit growth will probably widen if we try to bring down deposit rate too much & lending rates too much right now. Deposit growth is right now about 14% and credit growth at17.8%, so you would have a further widening of this gap. Over a period of time the imbalances would widen and come back to haunt us, so it will be effective only for a short period of time," he elaborates.
Ahya is expecting upside risk to inflation to be above 7.5% while core inflation may stick around 5% through FY13.
Most economists had blamed a tight liquidity situation due to RBI's monetary policy as one of the key factors for a low GDP in the fourth quarter of FY12. Here is an edited transcript of his comments. Also watch the accompanying video. Q: What did you take away from the IIP number? Do you think the Reserve Bank will note that or do you think it would have discounted it?
A: Yes, I would think so. I think we also got the GDP data point earlier on. So from growth perspective, there are enough indicators which are showing that growth is decelerating. I don't think the PMI is something which RBI will be taking into consideration. The hard data points on real growth will weigh more on their decision making. Q: Most people believe tomorrow's inflation might be key. Is there room or the possibility of a nasty surprise there?
A: Yes, I think consensus is expecting around 7.5% and we see some upside risk to that number, primarily on account of what happened to the rupee. The rupee depreciated in a big way in the month of May and that would probably have had an adverse effect on not only core inflation but also the headline inflation.
Also we are monitoring the daily food prices from the wholesale market and that is indicating potentially the YoY food inflation also accelerated in the month of May. So a combination of the rupee depreciation effect and higher food prices has meant that there is some upside risk to the consensus expectation on headline inflation and core inflation. Q: Within that key figure will be what happens on core inflation as you said. What kind of number are you working with?
A: Yes, we do think that core inflation will be around 5% range going forward. We also think that there could be some upside risk to that number over the next 2-3 months. As I mentioned earlier, one is on account of rupee depreciation and second is that we don't seem to have got a handle on food inflation.
There would be some kind of a pass-through of higher inflation expectations on account of food into core inflation as well. These are the two factors we need to watch and I would say that there is upside risk to core inflation while we have our base case around 5% for core inflation. Q: You are going with sub-6% now in terms of GDP growth. Would you say that call would change at all depending on what happens with RBI policy and rate cuts?
A: The RBI's inability to bring down cost of capital effectively is part of our bearish forecast and essentially, this comes on from the fact that we have persistently higher inflation. I think the question should be whether we will be able to get a control on inflation without having to sacrifice growth for longer period.
When we cut our growth forecast to 5.8% for March 13, that is precisely what we built in. We built in that this is an environment where it is going to take a lot to bring down inflation. The sacrifice involved in the form of lower growth for longer duration, will be much longer.
Our GDP forecast is in the range of 6%, right up to June 13, which is in the middle of next year. We have our GDP growth still going up at around 6.3%. I would say that it's going to be tough for us to have an effective reduction of cost of capital even if RBI cuts policy rates because of a stagflation type of environment that we are in right now. Q: That has been your case for a while, the 50 bps cut we got last time around was probably premature. Despite all the clamour for rate cuts this time around do you still maintain that a rate cut may not be the right decision?
A: Yes I would think so. The key number that we also have to look at apart from the core inflation is what is happening to headline inflation, particularly on CPI. The CPI headline inflation is at 10%. Now the system does bear that kind of inflation when you think from household’s perspective.
What will happen is we are going to see continued negative real interest rates for households. That will affect deposit growth and it will mean that even if RBI is cutting interest rates, you will not get a control on the cost of capital because a gap between credit growth and deposit growth will persist at a time when our loan deposit ratios are at an all-time high level.
I think somewhere the macro will resist that effective reduction in cost of capital. The best way would be to have a synchronous reduction in inflation across the board, headline as well as core, CPI and WPI. Then only can we expect an effective reduction in cost of capital. Q: What about the CRR? The SBI chairman yesterday spoke about the need for a 100 bps cut in CRR. Do you think that’s justified?
A: I think CRR cut should be used only when there is significant deficit in the interbank liquidity. At this point in time, the interbank liquidity deficit is in the range where RBI can manage with open market operations.
CRR cut should be used when there is a higher deficit of about Rs 100,000 crore on a daily basis for a persistent period of time in our view. Otherwise, we are still looking at that same old issue of inflation still not being in control and a loose monetary policy working against that objective. Q: Where does all this leave the currency? What kind of targets would you work with for the rupee now?
A: On a REER (Real Effective Exchange Rate) basis, the rupee has actually moved into undervalued territory. But in the near-term, the demand-supply imbalance which is supply of dollars and demand for dollars will overwhelm the trend in the rupee. It will be to the extent when we still have about USD 70-75 billion of current account deficit and the global environment is not supportive of getting a lot of capital inflows.
We think that the depreciation pressures will persist and that will probably mean that we will continue to trade in that undervalued territory a little longer, until the time the current account deficit is brought down to more manageable levels. Q: The problem as you note yesterday post-IIP pointed out as well is that there isn't really any trickle down in terms of these rate cuts and actually seeing rates coming down in the system. Do you expect that to happen come the second half of this year?
A: Yes, if you cut CRR and inject a lot of liquidity through OMOs, there will be a transmission into lower borrowing costs in the system. But we think it would not be sustainable because the gap between credit growth and deposit growth will probably widen if we try to bring down deposit and lending rates too much right now.
As we mentioned earlier, the deposit growth is right now about 14% and credit growth is about 17.8%. So you would have a further widening of this gap and over a period of 3 to 4 months time, the imbalances would actually widen and come back to haunt us. It will be effective only for a short period of time. Q: The only good thing which has happened on the macro front is that crude is sustainably trading below USD 100 mark. Do you see any improvement in the fiscal picture, something we should take heart from?
A: We can lay down the goalposts that we need to watch to assess whether the government is going to be able to manage its fiscal deficit on account of this decline in oil prices. The math as it suggests is that a large part of the fall in oil prices right now has been offset by depreciation of the rupee and whatever gain the government has made on account of decline in oil prices in local currency terms, is not meaningful enough.
If the government wants to achieve its budgeted subsidy of Rs 43600 crore, it will mean that they will have to increase the regulated fuel prices by upwards of 20%, which is still quite significant. When I am saying regulated fuel, it includes all of them.
If we don't touch LPG and kerosene then there will be that much more requirement to increase the diesel prices, which the current political condition is unlikely to permit the government to do. But yes, if they do that kind of an aggressive increase in regulated fuel prices, we can achieve some control on fiscal deficit and oil subsidies.