Implications Of RBI’s Credit Policy

The credit policy announced by the RBI Governor based on the recommendations of the MPC should be interpreted as a work in progress. This is so because in this new cycle of rate hikes the central bank has to react to the evolving conditions which are extremely volatile. 

Therefore, a rate hike of 50 bps in the repo rate which comes on top of the 40 bps hike invoked in May is the second in a series of rate hikes that can be expected during the course of the year.  

 The RBI has taken a rather aggressive view on inflation and revised the forecasts to 6.7 per cent for the year after starting with a forecast of sub-5 per cent before the financial year began. \

There will be three quarters with inflation of above 6 per cent which is reason for the markets to believe that there will be more rate hikes coming. The exact quantum of hikes and the sequencing of the same will be driven by the circumstances because the global economic situation is quite tenuous.

Crude oil price was largely stable at around USD 110/barrel but suddenly increased once China opened up and the EU put further restrictions on oil purchases from Russia. The price has been hovering around USD 120/barrel for some time now which looks like a new normal. Hence, one can never tell. We expect there to be another 50-75 bps increase in the repo rate during the year. 

 Therefore, we will have to be prepared to live with high inflation and interest rates during the year. From a household perspective, this will mean compression in spending especially on discretionary goods. Further, if leveraged in terms of having home loans the cost would increase automatically as most of them are linked to the repo rate. Hence, if the repo rate goes up to say, 5.5 per cent, with a 200 bps spread, home loans would cost 7.5 per cent compared with say 6 per cent, a year back. This cannot be avoided.  

Corporates will have to work around with higher interest cost as well as inflation. The larger ones may not be affected much with higher interest costs provided they see investment opportunity. The RBI has indicated that capacity utilisation rates have improved to 74.5 per cent which is a good start for further investment. The SMEs however will be affected negatively on account of higher working capital costs. This will also be an area for monitoring for banks which have restructured a considerable part of this portfolio. 

The RBI is sanguine on growth which is expected to be 7.2 per cent (which is also Bank of Baroda’s forecast). The Indian economy is largely domestic and hence global distortions have a secondary impact in terms of demand.

However, if inflation is unchecked it can come in the way of consumption and hence growth. These interest rate hikes when combined with the government moves on lowering excise rates on fuel products are to counter these forces. But growth nonetheless needs to be monitored as there can be a downward bias if things turn adverse.  

The market has been quite agnostic to the policy and the 10-year bond yield has come to less than 7.50 per cent which was the rate a day before the policy. There was nervousness about the overall tone of the policy and it does look like that the 50 bps hike was more or less expected (though Bank of Baroda had expected a 25-35 bps hike).  However, one can expect the market to continue being volatile in the upward direction.  

This will mean that as the government borrowing programme proceeds, the cost of borrowing would also increase proportionately. This can also imply that the RBI will work in parallel to control the upward movement of the yield curve. 

This will involve some amount of operation twist where the central bank buys and sells securities of different maturities without affecting the overall amount involved. Hence, for example, the RBI can sell 5 securities for a sum of Rs 2000 crore with different maturities and buy another 3 for the same amount. This has been used in the past to ensure that the yield curve is well behaved and anomalies ironed out. 

Further, what holds for the centre will also work for states, which normally borrow at 40-50 bps higher than the central government. Therefore state governments have to be prepared for reckoning with their borrowing at a higher cost.  

There is hence a gradual about turn taking place in the monetary space and one can get a sense of what the RBI means when it has reiterated the concept of withdrawal of accommodation. The RBI has kept CRR hikes out for the time being, which is good for the banking system because funds withdrawn through this route earn no interest and hence is a cost. 

At the same time, there is assurance that liquidity availability will not be an issue, which is significant given the large borrowing programme involved this year.  

Madan Sabnavis

Guest Author Sabnavis is chief economist, CARE Ratinigs and author, more recently of Economics of India: How to Fool all People for all Times