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Decoding RBI
The interpretation of how India’s economic contours have evolved since
the RBI’s last policy review in mid-June holds the key to the central
bank’s action at the 26 July policy meeting. Economic growth continues to
moderate as desired by policy actions but WPI inflation remains
uncomfortably high at close to 10% YoY. The RBI will remain focussed on
inflation and probably characterise the ongoing moderation in growth as
being uneven but largely anticipated and not yet sufficiently broad based.
It will reiterate the risk of external factors on India’s growth, but still hike
the repo rate 25bp to 7.75% and position itself to be one more hike away
from pausing at 8%. Thereafter, the evolving events in the US (more
monetary easing) and Europe (severe financial market dislocation due to
the ongoing sovereign debt crisis) and their global repercussions create
two extreme scenarios that will warrant different responses by the RBI.
The forthcoming quarterly review by the RBI on 26 July is the first policy
meeting since the government mustered some political courage to hike local
fuel prices in late June. The government’s biting the bullet indicated some
effort to check the undermining of monetary tightening due to the absence of a
more complete pass through of higher global crude oil prices. Economic
activity has been softening since early last year, even if the qualitative issues
with the monthly industrial production (IP) are discounted. The volatility and
revisions in IP data prompted the RBI governor to recently label them
“analytically bewildering”. Still, it is striking that despite the deceleration in IP
growth, core WPI inflation has been rising (Figure 1), possibly because input
price inflation is very sensitive to commodity prices.
Central banks’ guidance in their policy statements should be viewed as a
tapestry of their evolving thinking as the economic cycle shifts. In its 16 June
policy statement, the RBI maintained a hawkish stance, felt inflation was
uncomfortably high and would remain the key focus of policy. While it
acknowledged some moderation in growth, the slowdown was not interpreted
to be either broad based or undesirable. Also, the softening in commodity
prices in the run up to that policy review was not deemed significant enough to
downgrade it as a risk factor. Finally, the RBI correctly flagged that global
developments could pose a risk to India’s growth, but these were not
meaningful enough for it to take its eyes off the multi-headed inflation devil.
How have economic conditions changed since the last policy? Domestically, IP
and the PMI survey indicate further moderation in the growth momentum, as
desired by policy. Unfortunately, India’s IP time series continues to show too
much volatility and sizeable revisions, and probably exaggerates the pace of
moderation. For example, gross direct (+23.9% YoY) and net indirect (+32%)
tax collection in April-June hint of a better tone of aggregate demand than what
is indicated by IP. Still, just as the post-crisis recovery was uneven, the ongoing
deceleration too is uneven. Investment spending is being affected by policy
inertia although higher interest rates do not help. Consumer spending that is
sensitive to interest rates (e.g. vehicle sales) has already been slowing, but
rural-based private consumption should be more resilient
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It is often overlooked that while IP data are one of the few real economic
activity indicators available on a monthly basis, the overall industrial sector
accounts for only about 26% of GDP, while service sector accounts for a hefty
54.7% of GDP. Consequently, India’s GDP growth tends to be far less volatile
than the volatility in IP (Figure 2). Overall, the IP data are still supportive of
our forecast of 7.5% GDP growth in FY12 (FY11: 8.5%), an outcome that
implies couple of quarters of near 7% YoY GDP growth rates.
More important is the fact that WPI inflation remains uncomfortably high
(Figure 3), and will likely remain the key focus of the RBI, especially the
higher-than-trend non-food manufactured goods (core) inflation. Headline WPI
inflation increased to 9.4% YoY in June from 9.1% in May. At 7.2% YoY in
June, WPI-core inflation was similar to 7.3% in May. Note that the data for
May and June are preliminary and will be revised up to show inflation at 10%.
No change to our forecast of WPI inflation at 7.5% by Match 2012(RBI: 6%).
Equally worrying is the pattern of sizeable (around 1ppt) revisions in the
preliminary WPI inflation in the last several months. To be sure, April WPI
inflation was revised significantly higher to 9.7% from 8.7%. The magnitude of
revisions so far in 2011 has averaged around 1ppt, much higher than the 0.3-
0.5ppt that is more typical when inflation is showing a rising trend. Overall, the
RBI cannot just shy away from hiking rates when inflation has actually risen
and revisions to the inflation data remain worryingly high
We have consistently maintained that monetary conditions are tighter than what
the level of the repo rate indicates. This is mainly due to the tight domestic
liquidity conditions engineered by the RBI, which has made the monetary
transmission more effective since late-2010. As a result, lending rates now are
as high as they were at the peak of 9% for the repo rate in 2008 (Figure 4). This
is despite the current repo rate being 150bp lower that the peak in 2008.
We maintain our expectation of a 25bp hike in the repo rate to 7.75% on 26
July as the RBI will remain focused on checking inflation. However, as the
moderation in growth becomes more broad based and inflation peaks in the 10-
10.5% YoY range in July-September, the RBI is likely to pause once it reaches
8% on the repo rate. Admittedly, significant global financial dislocation in the
run up to the 26 July policy could still force the RBI to temporarily hold fire
but that is a conditional outcome.
International crude oil price has a significant impact on India’s inflation and
consequently on the RBI’s monetary policy (Figure 5). Brent is slightly higher
now than it was at the time of the last RBI meeting in mid-June. A key input in
our expectation of a pause by the RBI is that the global risks could be two
sided. A blow up in Europe could cause commodity prices to correct, thereby
offering scope for the RBI to subsequently ease policy to deal with the crisis.
However, adoption of more monetary easing in the US could cause commodity
prices to move higher, thereby warranting further tightening by the RBI. Given
the nature of the extreme outcomes that warrant different responses from the
RBI and the lack of certainty about the timing or even the likely outcome, the
central bank will prefer to adopt a wait-and-see approaching, after hitting 8%
on the repo rate. At that level, the RBI would have increased policy rates
effectively by a hefty 475bp in the current tightening cycle.
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