India rate cut revives debate on RBI strategy

Posted on October 12, 2016

When Raghuram Rajan announced in June he would soon leave the Reserve Bank of India, some commentators were quick to declare the death of the monetary prudence that he imposed during his three years at the helm.

Concerns that the government would seek to replace him with a pliant dove, easily swayed by its calls for easing to boost growth, were allayed in August when it appointed Urjit Patel: Mr Rajan’s deputy — who had crafted the inflation-targeting architecture — was a key part of the old regime. 

But the first monetary policy meeting under new leadership last week — which brought an immediate 25 basis point rate cut — has revived debate in Mumbai about whether the RBI will ease its focus on taming inflation in order to boost growth. 

Mr Rajan, who took over at the RBI after months of damaging capital outflows, helped to restore investor confidence by raising the base rate to damp inflation, while launching a big drive to force banks to take action on the multibillion-dollar distressed loans that had accumulated on their balance sheets. 

But he faced heavy criticism from some prominent figures in politics and business, who argued that his interventions had undermined growth by chilling corporate lending. Amid that controversy, and with the government still silent on whether it would renew his contract after his initial term expired on September 4, Mr Rajan withdrew from consideration.

As a senior figure in the existing regime, Mr Patel stood for continuity more than any of the other figures putatively in the running, and it would be simplistic to view his debut rate cut as evidence of dovish bias, says Pranjul Bhandari, an economist at HSBC.

Mr Rajan — who ordered five rate cuts in the last 20 months of his tenure after bringing inflation under control — might have made the same move were he still in charge, she argues. Good monsoon rains this year have brought down food prices, helping consumer price inflation to fall to 5 per cent in August: well within the RBI’s target range of 2-6 per cent.

Markets had broadly priced in the prospect of a rate cut. The benchmark Sensex index ended the week 0.6 per cent lower than its closing level the evening before Tuesday’s decision, while the rupee lost a mere 0.1 per cent against the dollar over the same period. The yield on Indian 10-year government bonds tightened from 6.90 to 6.85 per cent. 

But more than the rate decision itself, which took the base rate to 6.25 per cent, it was the accompanying remarks from Mr Patel and colleagues on the monetary policy committee that have sparked talk of a dovish shift: in particular, their revised estimate of India’s “neutral” real interest rate, or the real rate consistent with stable inflation and growth in line with potential.

“The rate cut was justified not on the basis of an inflation undershoot … but by tweaking the framework,” wrote economists at Nomura of the new neutral rate estimate of 1.25 per cent, down from 1.5-2 per cent.

In a speech two days after announcing he would leave the RBI, Mr Rajan had highlighted as one of his big accomplishments a return to positive real interest rates, after several years in negative territory that penalised savers and undermined a drive to encourage greater use of the formal financial system.

But Sanjeev Prasad, head of research at Kotak Institutional Equities, argues that the RBI has been given more leeway on this front by a government crackdown on tax evasion. This has made it harder to dodge tax by funnelling savings secretly into real estate and jewellery, reducing the appeal of those asset classes relative to financial products, he says.

New inflationary pressures could yet emerge: a big pay increase was recently announced for public servants, while a new national sales tax could add to inflation if set at a high rate. An RBI survey in September showed that households expect prices to rise 11.4 per cent over the next year.

But with the RBI relatively sanguine on the outlook — it predicts that consumer inflation will decline to 4.5 per cent in March 2018 — private sector economists are anticipating another rate cut to follow in the next few months.

More easing will result in a strengthening Indian rupee, predicts Sean Yokota, head of Asia strategy at SEB. India’s equity market is more open than its debt market, he notes, meaning that inflows into the former would more than outweigh outflows from the latter.

Rate cuts should also lead to shifts within equity portfolios, say analysts at Credit Suisse, who recommend clients to increase exposure to housing finance and construction companies.

Yet the economic impact of rate cuts over the past two years has been held back by troubled balance sheets at state-controlled banks, which account for about three-quarters of sector assets, and have passed on only about 40 per cent of the easing to their borrowers, according to India Ratings and Research, a credit-rating agency.

Mr Rajan oversaw a big drive to flush out bad assets, forcing banks to recognise and provision for billions of dollars in distressed loans, while rolling out several schemes to encourage restructuring of such assets. 

Banks using one of those schemes will, it emerged last week, be allowed to account for restructured debt as a standard asset, casting a more favourable light on their balance sheets. The move so early in Mr Patel’s tenure — coupled with his promise to approach the bad loan problem “with firmness, but also with pragmatism” — has fuelled speculation about a relaxation of the pressure that Mr Rajan exerted on the banks after years of regulatory forbearance.

Such suggestions could prove unfounded, says Ms Bhandari, arguing that the two governors’ contrasting communication styles may have led to unwarranted inference of meaningful policy differences. “I don’t think anything Mr Patel has said or done has been vastly different to Mr Rajan,” she says. “We shouldn’t read too much into everything he says.”

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