The Reserve Bank of India (RBI)’s monetary policy committee raised the repo rate by 50 bps to 5.4 percent on August 5, largely in line with the market expectations. This is the third consecutive rate hike by the RBI taking it to a total of 140 bps in the repo rate. However, when seen in conjunction with the floor of the policy rate (SDF rate) and liquidity moves, the total effective increase stands at ~180 bps in just about a quarter.
The MPC also retained the policy stance at ‘Withdrawal of Accommodation’ to emphasise inflation control, and impart flexibility to the policy given global uncertainties. Even though the rate hike was unanimous, MPC member Prof. Jayanth Varma expressed reservations about the policy stance.
While the RBI sounded hawkish in its intent to tame inflationary pressures, it is heartening to see the confidence the bank reposed in the growth recovery by keeping the growth projections unchanged at 7.2 percent for FY23. High-frequency indicators such as railway freight, traffic, port freight traffic, e-way bills, and domestic air passenger traffic show an overall improvement in demand. Importantly, capacity utilisation now stands at 75.3 percent, above its long-run average of 73.7 percent. Credit growth has also improved with double-digit growth in May and June.
But what does it mean for the various segments of the economy?
The long-term costs of allowing inflation to become entrenched far outweigh the short-term ones of bringing it under control, and higher inflation persistence could threaten to upset the hard-fought recovery. A safe and soft-landing of growth is the best remedy for staving off the global woes.
The RBI’s confidence in domestic economic recovery and its endeavour to lower inflation will help support long-term growth. With this policy, the RBI seems to have frontloaded the bulk of its interest rate hikes. Going forward, the pace of rate hikes may be calibrated and slow. With our assumption of a terminal policy rate in the range of 5.5-6 percent by the end of this year, there could be another 20-25 bps hike in this short but swift cycle before a pause.
The RBI has done a great job of bringing the spotlight back on the external sector. While the rupee has seen deft management by the RBI so far but there will be a lot of scrutiny on the health of India’s external accounts. CAD/GDP in the current fiscal may be much less compared to pre-taper tantrum levels in percentage terms, i.e. 3-3.5 percent of GDP vs 4.8 percent in FY13, the absolute levels of CAD is poised to be a lot higher than the $88 billion in FY13. This magnitude of CAD in absolute terms highlights the funding challenge India faces, and sticks out as a sore thumb at a time when global financial conditions are still likely to tighten more. The rate move will lower the interest rate differential with the dollar, help CAD via domestic demand compression and provide support to the rupee.
The latest rate hike will raise borrowing costs for corporates and individuals even further. Transmission thus far has been swifter than in the past rate cycles, and lending rates are up by 43 bps as against the repo rate hike of 90 bps.
Bank loans rates are expected to rise due to faster transmission under the EBLR framework. Since most of the MSME (~70 percent) and retail loans (~50 percent) are linked to external benchmark, they will face the brunt of the recent tightening cycle.
However, large industries are mostly insulated as they have only ~20 percent of the outstanding loans linked to external benchmark.
While borrowing costs will certainly go up further, it may not affect high-end consumption as much which remains buffeted by a combination of forced savings and wealth effect. However, consumption at the lower end of the pyramid will likely be impacted due to the lagged effect of rising borrowing costs. However, note, over the medium term, lower inflation will raise real incomes and provide relief to households living on tight budgets.
Thus far, the deposit rates have been revised higher for the institutional borrowers, but it will feed through to retail depositors too going forward. Given the faster transmission, senior citizens, bank account holders, and fixed deposit investors may see interest accruals going up. This should give a much-needed fillip to the savings economy.
(Sarbartho Mukherjee, economist, M&M, contributed to this article.)Sachchidanand Shukla is Chief Economist, M&M Group. Views are personal, and do not represent the stand of this publication.