Monetary Policy | RBI delivers a hawkish surprise

“Pandemic has scarred our psyche and tested our resilience, but we have responded with bold, unconventional and resolute measures.”

Anyone who was focused on the benchmark repo rate at the April policy review missed the woods for the trees. Action lay elsewhere.

First, policy guidance was tweaked to focus on ‘withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth’ which essentially takes inflation back to the centre of the policy dashboard. Second, the width of the Liquidity Adjustment Facility (LAF) corridor, around the repo rate, was restored to pre-pandemic levels, bookended by the newly instituted Standing Deposit Facility (SDF) rate at 3.75 percent while the Marginal Standing Facility (MSF) was retained at 4.25 percent. This SDF rate is tantamount to an indirect tightening of 40bp, as the fixed reverse repo rate stays at 3.35 percent, and is fast losing relevance.

Next, departing from previously held expectations for inflation to moderate, the FY23 CPI forecast was revised up sharply by 120bps to 5.7 percent while geopolitics is seen as a risk to confidence and spillover from commodity channels posing an additional headwind. To reflect this local-global mix, the FY23 GDP growth forecast was cut by 60bps to 7.2 percent. Underpinning all these forecasts is a 26 percent jump in the crude oil assumption of $100pb.

The tweak in the guidance to acknowledge the need to start the withdrawal of accommodation leaves the June rate review live for a change in the stance to neutral. With upside risks to the 2QFY23 inflation projection, the first repo rate hike might be delivered in August, and thereafter towards end-2022. We retain our expectations for 75bps worth rate hikes in FY23, concentrated in the second half of the year. Local considerations will still trump global policy normalisation. i.e., even in the face of the US Fed pursuing an aggressive rate hiking cycle; it is amply clear that the RBI is unlikely to respond with a larger or faster quantum of hikes.

The hawkish surprise from the central bank led the 10Y bond yield to test past 7 percent to a three-year high along with an uptick in 2Y and money market rates. Besides the extension and increase in the held-to-maturity requirement for banks that will potentially draw additional demand for bonds, markets still await clear signals on the shape and form of the central bank’s support.

Our Financial Conditions Index (FCI) with the latest market prices spanning FX, credit, equity, and bond markets, suggests that financial conditions are accommodative and conducive for recovery. We will be watchful for any spillover from policy normalisation by global central banks.

Meanwhile, while the stock of liquidity remains large at this juncture, the flow is likely to moderate. Amid the pandemic in 2020, the RBI balanced a dollar deluge (on strong flows and FDI), fending off appreciation pressures on the rupee. Persistent intervention (via dollar buying), besides open market operations, added to the already flush rupee liquidity surplus.

These dynamics are likely to change in FY23. With the US Federal Reserve not only signalling a higher quantum of hikes but also likely to be frontloaded, flows into emerging markets will be subdued.

Domestically, lack of clarity on bond inclusion plans has tempered incremental passive foreign inflows into debt. At the same time, the current account deficit is expected to widen, pushing the balance of payments (BOP) to a modest deficit. The BOP deficit and the likelihood that the central bank will intervene to keep rupee depreciation in check will have affect domestic liquidity.

Considering the significant liquidity surplus this time around, and the RBI only absorbing via multiple tenor variable reverse repo auctions, we don’t expect the BOP deficit to push liquidity to a deficit but slow the pace of incremental rise. This is also in sync with the central bank’s intention to keep liquidity flush (likely ~Rs 3-4 trillion) to avoid premature hardening in financial conditions, while allowing for natural drivers, namely lower currency in circulation, the balance of payment deficit, and higher domestic assets to correct the scale of surplus rather than direct liquidity absorption measures. Add to this, he RBI plans to conduct a second sell/buy FX swap of $5 billion in April, which besides elongating the maturity of their forward book will also absorb rupee liquidity to create the headroom for bond purchases. This durable drain will defacto create headroom for the central bank to conduct more open market operations or GSAP (~Rs 2-2.5 trillion) without adding to the already flush conditions.

The change in these undercurrents is likely to keep the currency on a gradual depreciation path. We entered the year expecting the Reserve Bank of India to be active in defending the currency after an extended period of fighting-off appreciation pressures. Reserves are put to their intended use, i.e., slow rupee volatility but not reverse its weakening trend, and this inclination is likely to continue.

Radhika Rao is Senior Economist and Executive Director, DBS Bank, Singapore. Views are personal, and do not represent the stand of this publication.