See rate cut on Tuesday, but what can RBI do thereafter?

Rarely has an RBI policy been so keenly awaited by markets, the economy and citizens. For three years inflation seemed never to fall, and for the past three quarters growth appears never to rise. What are the options before the RBI, what will be the impact of its actions given the climbing current account deficit, an entrenched fiscal deficit and an unstable and slowing world economy where central bankers stand ready to flood more cash?

SBI MD Krishna Kumar, Citibank MD and Head of Trading Soumyo Dutta, Goldman Sachs MD and Chief Economist Tushar Poddar and ICRIER's Consulting Economist Renu Kohli join CNBC-TV18’s Latha Venkatesh to discuss the options the RBI has in front of it, and the impact of its actions. Below is an edited transcript of the interview. Q: You have been hooting for a rate cut and for several more to follow. What is the compelling case? Poddar: I think there are several; core inflation should be key to a monetary policy decision and core inflation is coming off sequentially as well as year on year. We are expecting it to be about 5% for the month of March. So that takes away any reason for the central bank not to cut rates, especially when rates are so high that it is really biting the economy. You cannot have GDP growth at 6%, core inflation at 5% and rates at 8.5%. So the RBI needs to cut and needs to continue to cut for a while. Q: I take your case, but what are your forward looking inflation numbers and therefore how much headroom does the RBI have? Poddar: I think you have to make a distinction between headline and core inflation. Headline there are still some concerns about suppressed inflation in energy prices, food prices and fertilizer prices. But I don’t think that there is too much suppressed inflation in core, especially if you look at demand side pressures, which are really non-existent at this stage. Even taking the worst case potential growth numbers for GDP at 7%, we are growing somewhere around 6% right now. There is a negative output gap, so I don’t think that there is much scope for core inflation to rise up from here. I see this suppressed inflation as a headline problem not as a core problem. Q: You weren’t so confident that Reserve Bank has so much of headroom. Atleast two compelling reasons against the rate cut would be that current account deficit is becoming a huge problem and savings have been falling. Do you think there is a case right now to cut and how much of a headroom? Kohli: There is a case for cutting as far as you can make out from the growth side. Definitely demand pressure has eased, which were responsible for inflation, but at the same time the key risks that RBI had flagged in the past recent reviews of monetary stance were crude oil prices, fiscal position and suppressed inflation. Of the three of these, crude oil prices still remain elevated and suppressed inflation is yet to pass through because administered prices have not been revised. Monetary policy needs to move ahead of economic activity and looking ahead at CPI, which is the new series, has still moved up to from 7.7% to 8.8% in February. Going ahead I think all these risks remain, so certainly I would say that there is not much scope of an argument for a rate cut on the basis of inflation. But yes if the RBI does want to look at growth a little bit more, perhaps there are equally strong arguments from the growth angle. Q: So would you say one cut or would you say very little by way of cuts? How many do you think the RBI can do, 25 bps or 50 bps? Kohli: It should be more of a symbolic rate cut of about 25 bps. There are two other asymmetries which have moved ahead or on to the center stage on the RBI’s policy reaction function, so its wider as it were. It’s not just growth and inflation, there is this enormous current account deficit and if the RBI shifts its weight or stance in favor a little bit towards growth, then one of the pressures on the current account will increase. Q: Do you think that the current account deficit of 4% is going to become a very huge problem? Dutta: I agree, current account deficit is definitely a problem and its one of the new variables on RBI’s radar and they should be worried about it. At 4% or USD 70 billion, it’s definitely not looking pretty. But how much of it can be engineered by means of forward points, I have my doubts on that. We have seen that forward points are typically an interplay between funding curve and a currency play. At time, currency play rules and at times funding play rules. If it’s is suddenly Rs 1 and importers find it very cheap to cover their imports, yes there would be huge amount of cheapening of imports, which clearly is not in RBI’s radar. But it can’t come to that kind of level because much before that there will be lot of other players who would be wanting to pay that kind of forward points or premium and lock into a funding curve because then funding becomes cheaper. So, the NR flows, the ECB flows, all the foreign currency borrowing flows converted into local currency that suddenly becomes cheaper, so there is an automatic balancing going on that way. Q: So your own sense is that the RBI has an headroom to cut and cut much more than just 25 bps? Dutta: What worries me are quite a few factors. For example, a negative fixed capital formation for two quarters; if you see, those numbers are worse than the height of crisis that we had in 2008. So these things typically should not happen in a growth cycle. The other thing which is clearly of concern to me is GDP now at 6.9%, then trending to 6.1%; what does it take to take it to 5% if the current tightness remains. Liquidity tightness is clearly a problem and manufacturing is definitely feeling the heat. So new capacity creation, supply side bottleneck, all these things that you have been talking about they are really not being helped greatly by this kind of tight liquidity and high rate environment. Q: Since you speak to people who are interested in capex all the time, really how important is interest rates for capital expansion? Kumar: I believe that certainly people who are putting up projects and setting up fresh manufacturing facilities do look at interest costs as one of the major factors. But then the reason for capex not taking place is probably not that interest costs are high, but more the feeling that there is no potential or there will be no potential demand for the product which is being set up, the product which going to be manufactured. So that is more of an issue rather than the interest cost. _PAGEBREAK_ Q: For two years or a more we have had a negative real interest rate and that is already beginning to impact savers. May be not the only reason, but that’s clearly one big reason why savings rate is going down. Do you think even if a rate cut happens, you will have the luxury of cutting down deposit rates much? Kumar: What you are saying is absolutely right. There is a big dilemma right now. Even if the RBI does cut the policy rates next week, the re-pricing of the liabilities might take time, in the sense that it might take a couple of weeks or a month. But if there is a rate cut of a fairly reasonable magnitude, say 25 bps on the repo side and may be yet another 25 bps on the CRR side, there could be some readjustment of the rates at the longer tenure in terms of deposits. I don’t see any major change in the short end deposit rates. Q: Assuming there is a rate cut, what do you think you will be able to move on? Will you be able to cut deposit rates and lending rates in the same proportion? Kumar: The industry would certainly look at cutting interest rates for the industrial segment. May be not immediately or in the same week the rate cuts are announced. There might be a time lag. I would say a time lag of about a couple of weeks or a month before the rate cuts take place. I do not believe that it would be the cuts in the deposit rates and the cuts in the lending rate if they happen would not be in the same proportion because banks would also like to maintain to some extent their net interest margins. Q: So you would expect more deposit cuts and less of lending rates? I thought people would cut more of lending rates because you want money to move? Kumar: That’s true, but then it depends on sectors. It will not be an across the board reduction of interest rates. Q: Will there be more of lending rate cuts or more of deposit cuts? Kumar: My sense is there would be a little more of deposit rate cuts. That my immediate reaction to that. Q: Is it the savings rate and the investment rate that has give us this secular 8% growth? Does the RBI have much headroom on the savings rate front? Poddar: Let’s first dispel the notion that a rate cut is going to worsen the current account deficit. Current account deficit is nothing but the savings investment balance, which is equal to the current account deficit. So what you want to do is boost private savings as well as public savings. On the public savings side we have seen the problem with the fiscal deficit, the direction though is in the right way – the trajectory. We don’t want too much of a fiscal cut at this stage because that’s going to act as a drag on growth. So, we have to do it in a calibrated approach – in a medium term sustainability framework. On the private side what you need is to see growth coming back. That influences depositor behavior and you want to see inflation coming down. As long as people’s expectations about inflation come down private savings will pick up. Private savings has not really fallen that much, it’s really public savings which is causing the rise in the current account deficit. Q: Household savings in the financial sector has fallen so sharply. Poddar: It’s because of a move away from financial savings to physical savings, which is a different issue. We do have this demographic tailwind behind us in terms of the savings rate. So, I think that if you can start the growth process again the savings will follow as it normally does. It is highly pro-cyclical. So, I don’t think we should confuse a current account deficit with rate cuts. Rate cuts will do nothing to worsen the current account deficit; in fact it may actually help meliorate it. Q: How do you think bonds are going to respond if there is a rate cut, atleast for the next 4-6 weeks, what kind of a range do you see? There is one guess out there in the market which believes that bonds would go 8% by September 30, where do you stand? Dutta: For the next 4-6 weeks horizon, 8.25% can be a floor. 8% yes provided RBI surprises us with a 50 bps rate cut. Otherwise I think 8.25% and 8.75%, I would put that as a range for the time being. Clearly what is also an important factor in that market right now is RBI’s Open Market Operations (OMO) and how much they come in, in the secondary market and how much they buy in the secondary market, that’s clearly going to determine the price action. But I think with 25 bps cut I wouldn’t be very ambitious. For example, if you see from 8.80% after the first auction of the fiscal year, we are already down 8.45% kind of levels. 35 bps it has pretty much come off in anticipation of this, so it’s pretty much priced in there. Q: So, you would put the range from 8.25% to 8.75%? Dutta: Yes, 8.25% to 8.75%. Q: What are you penciling in by way of credit off take and deposit growth at all this year? Kumar: For the year 2012-13, we are looking at a deposit growth of anywhere between 25-30%. I know that’s very optimistic, but we think that we can pull it off. As far as the credit off take goes, I would say in the range of 20-25%, but we are yet to finalise the numbers, but it’s going to be in that range. One point is very clear that all our guests here are expecting a rate cut on Tuesday itself. The debate really is on what the RBI can do thereafter.