Wow! Early morning surprise by the RBI Governor: A rate cut of 25 bps on repo, pushing it from 8% to 7.75%. The other key rates and availability of liquidity under other windows such as repo have been kept constant. While I have been rooting for a rate cut for some time now, I must confess that I had thought that the Governor may choose to unveil the same only post-budget.
So, what has changed since December, except that India is now “used to” zero WPI inflation? I think that a big angle is that there is more certainty now, than in December, that the globe will remain a low interest rate place in 2015. So, a reduction in the Indian rates will not pose a threat of us being the only country out of synch with the others, causing pressure on the exchange rates. Here are a few factors that could have finally persuaded the inflation warrior to give a smallish rate cut, if only on repo:
- The world is confirmedly on a “soft” platform now. Multilateral agencies including the World Bank were looking at a global GDP growth rate of about 3.2%- 3.4% for 2015 and that has since December been revised downwards to 3%. It is, as usual, fruitful to remember that the 3% growth rate has long been a psychological benchmark for gauging “global recessionary” trends. In a soft growth world, there are lesser chances of interest rate hikes by any of the major trade partners of India and hence an interest rate reduction would not really put our monetary stance out of synch with any other banks’ stance.
- In particular, it is important to look at what Ms. Yellen is thinking if you want to analyze how Dr. Rajan works. In the past 3 months, the US data has been increasingly upbeat. The growth rate has firmed up nicely to about 2.5%, a long cry from the negative growth rates witnessed during the sub-prime. At the same time, the unemployment rate hit a 6-year low of 5.8% and in the month of December, the Fed was quoting that it could go further down to a level of about 5.3% by September 2015. In fact, the UK magazine “The Economist” made a remark tongue-in-cheek that the US seemed to be on a “rude” growth spree, growing at a time when the world was looking forlorn. Based on the growth and labor numbers, the Fed was increasingly hinting at a rate hike that could start in February or March 2015. What was not expected then was the oil could actually fall to $40 in January 2015. Now this fall in oil has had two consequences on the US interest rate prospects. First, of course, it has reduced the inflation levels in the US significantly, cooling the prospects of an immediate rate hike. What is now largely being said by analysts is that Ms. Yellen may now choose to spend the next 6 months “preparing” the markets for higher costs of borrowing. Second, a large chunk of those shale investments that will be hit by the reduction in crude are concentrated in the US. And hence, even as inflation falls, there is a hint that the investments in oil and gas in the US could also take a hit in 2015, thereby supporting the fact that those rate hikes in the US will be postponed some more.
- In the meanwhile, the East is faltering. China is on a deliberate slowdown mode and is grappling with its internal issues of banking, investments and growth. Japan, which has been frustrated with its deflationary history, is now facing issues as the price indices move predictably downwards with the crude oil softening. The Eurozone too is on the verge of a recession and the falling oil prices mean that the interest rates will stay low.
- Lets talk about Russia, where the interest rates have been….raised. Now, there is big trouble brewing there. Firstly, there was the issue wherein Crimea, which was a political part of Ukraine was separated and attached to Russia in March 2014 by Putin, a move which the EU has not taken to nicely. This caused the EU and the US to raise sanctions against Russia, which hurts their trade and investment prospects significantly. Secondly, Russia seems to be plagued by the notorious “Dutch disease.” Dutch disease describes a phenomenon wherein a country starts exploiting a natural resource sharply (in the Russian case, oil, which became its “lead” sector) and emerges as a chief seller of that commodity in the international markets. As the oil prices in the world increased from 2010 to early 2014, the Rouble too maintained its levels nicely, making it cheap for Russia to import the “non-oil” or the “lagging” sector commodities. So long as the oil prices were high, Russia had the FOREX to finance imports of the non-oil commodities. It also implies that in an appreciating Rouble phase, Russia would be privy to “cheaper” borrowings from abroad, which would help further the investments in the oil sector. Now with the falling oil prices and the sanctions, the export revenue of the economy stands massively reduced. This would put a pressure on FOREX reserves and/ or the exchange rate, and as we have seen, both the variables have been under significant pressure. The depreciation has meant that the cost of the repayment of the debt and interest has increased manifold. At the same time, the sanctions imply that the lenders are not really in a mood to roll-over any of those fast-maturing debts. Even if Russia increased her interest rates overnight, from 10.5% to 16%, this kind of an interest rate hike is not reflective of any regular monetary policy stance and does not fool anyone at all. In fact, such interest rate hikes are normally subjected to Catch 22 processes- the fact that the rates have been hiked tells everyone loud and clear that there is trouble; capital outflows post-hikes are normally notoriously higher than they were before. Thus, I do not think any Central Banker would be currently worried about being out-of-synch with the already-out-of-synch Russia.
- And then, there are the domestic factors. The Modi statement that the Government will not interfere with the workings of the banking sector has brought a hitherto unseen warmth in the Central Bank-Central Government relationship. Economically speaking, the fact is that not only the CPI and the WPI, but also the core inflation has shown significant slackening in December. Core inflation, since it removes the effect of food and fuel, is largely indicative of demand conditions in the manufacturing sector. Thus, softness in demand in manufacturing, low crude prices, lower than expected prices of foodgrains, especially cereals, and most interestingly, a reiteration of the commitment by the Modi Sarkar to stick to fiscal discipline, all suggest that price pressures in the immediate 6 months would not be daunting.
- A final, and slightly technical point. The reduction of 25 bps in the repo does not really change the dynamics between the call money market rates and the LAF corridor since the call rates have been roughly at 7.50%- 7.60% levels in the past quarter, even when the repo was at 8%. Thus, the repo volumes need not really see a huge jump immediately even if the repo stands slashed to 7.75%.
Nice move, Governor. A signal, that we are looking at a softer interest rate regime in the next 6 months, without really affecting the real dynamics in the market.