RBI should reduce the repo rate at the next Bi-monthly Policy Statement on September 29, 2015

RBI Watch                                                                                    Monetary Policy 2015-16

Please read my blog of September 2, 2015. 

The August CPI figure confirmed that for the second consecutive month inflation was below the 4% level. RBI's projected path to January 2016 expected inflation to fall to 4%, and then a rise to 6%.

It looks very unlikely now that inflation will rise to 6% by January 2016.

My blog earlier today showed the unusually weak state of growth of bank deposits and lending. Till now the RBI's hands were tied down by the fact that inflation was high. But this is no longer the case now, even by the RBI’s own projections.  

The RBI, by most indicators, should now reduce the repo rate once again. Lending needs to be given another boost. As with many acts in policy making, everyone may not benefit.

Depositors are likely to receive less from banks. Or banks should be willing to reduce their margins; thereby attracting depositors, and resisting a further slowdown in their business.

Bank lending and deposits show an economy in very weak shape

Growth of lending and deposits at record lows in the last twenty years

RBI Watch                                                                                    Monetary Policy 2015-16

The graph below charts the growth of bank deposits and credit on a financial year basis from 1991, the year economic reforms were initiated in India.

During this period, the growth of bank credit peaked in 2004-05 at 31%. Two years later, in 2006-07, deposits also saw their peak at 24%.

Both the growth of credit and deposits has pretty consistently declined since. At the end of the last financial year, 2014-15, credit growth fell to 9% and deposit growth to 11%.

In fact, the deposit growth in 2014-15 of 11% is the weakest since 1990-91, and this is also the case with credit growth, barring 1991-92!

Are there signs of a change during the current financial year, 2015-16? The table below shows the numbers till August 21, 2015 – the last date up to which RBI data is available.

The picture is not encouraging, although better than the same period last year: credit has grown by just 2% and deposits by a modest 5%, when a month short of half of the financial year is behind us.

Federal Reserve chooses not to raise the Fed Funds rate

I refer to my recent blog on this subject, where I thought the Fed would not raise the rate. Please see the short statement from the Federal Reserve.

More when I get some time.

Martin Jacques' view: putting China's current economic situation in perspective

Please read this article that appeared in the The Guardian on September 14, 2015

The value of the Rupee: update as of August 2015

RBI Watch                                                                                               Indian Rupee

August was a momentous month in the currency markets: China moved towards a more market determined yuan rate - this led to a 2% depreciation of the currency on August 11, the largest in two decades.

During the month, the rupee weakened 3.5% against the US dollar, and also fell against the pound sterling, euro, and japanese yen.

Over the last one year, emerging market currencies have fared poorly against the U S dollar - some are at all-time or close to all-time lows. In this context, the rupee's performance has been relatively good. 

The last one year has also seen a huge outflow of capital from the emerging markets. Here again, India has fared relatively better.

As at the end of each month, the two tables below shows the rupee in nominal and real terms against a 36-currency trade weighted basket. The bottom line is that the rupee continues to be overvalued in real terms.

The RBI's stated policy is not to set a target level for the rupee against the dollar, but to only intervene in the markets to smoothen the volatility of the currency. 

Given the possibility of turbulent times in the financial markets in the months ahead - a rise in interest rates in the US, and the possibility of a China shock are two possible sources of turbulence – the rupee could well be under renewed downward pressure. Using the foreign exchange reserves to defend the currency could be appealing, but would be perhaps counterproductive. 

A more competitive rupee could give a boost to the economy, and given the falling inflation trend is unlikely, on balance, to create inflationary pressures.

Will the Federal Reserve at the FOMC meeting next week increase the repo rate?

Virtually everybody agrees that the Federal Reserve (Fed) needs to raise the repo rate. The question is will the Fed raise the rate next week or will it defer the decision to October/December or perhaps even early next year?

The argument for and against have been put forward recently in the Financial Times by two reputed economists.  Readers of my blog would best be served by reading it.

My view is that at this juncture it is perhaps better for the Fed to hold off raising rates till December.

There is the recent argument that the Fed has created uncertainty in the minds of market participants: they were   expecting a rise, and now – given fear of a potential China shock and contagion – they are not sure whether the rise will materialise. The argument goes on to add that there will always be some unknowns for the Fed., so it is best to act now rather than wait.

While there is some truth to this argument, the fact is that the Fed has eased uncertainty for over a year: it announced that the next move in interest rates is going to be up about a year ago, and this gave participants time to take action – the massive and arguably unprecedented outflow of capital from emerging markets over the last year was partly a result of this guidance by the Fed. , and this has eased the transition process of the reverse flow of capital to emerging markets.

It is unlikely that, on its own, a Fed. decision to raise the repo rate next week will create a major furore in the financial markets. But if this is coupled with a China shock and contagion, then the result could very well be different. Recent turmoil in the financial markets is a warning sign.

Second, there is really no pressing imperative for the Fed to raise the repo rate: inflation in the US is very benign, and there is yet no clear sign that it is likely to surge ahead, and the world has witnessed a deflationary commodity shock, which by most accounts has not run its full course.

In fact we could be facing a ‘new normal’ in the US: a period of steady growth in the region of 2 -2.5% with inflation below the Fed’s target of a healthy level of inflation of 2%.

Yet, there is, I believe, a sound reason for the Fed to raise rates – the Fed needs to normalise interest rates. With inflation in the region of 1.5%, under normal circumstances, the Fed’s target for the repo rate would be 3 -3.5%, against a background of an economy growing at 2-2.5% with unemployment at low levels. Savers getting a cipher on their bank saving is creating distortions in the economy.  And it is just not fair.

If in October/December, purely on domestic grounds, the Fed gets clear signs that it is imperative to raise the repo rate and we have no China shock (even a hard landing is fine), then it should do so.

An inflation number below 4% for August may well prompt the RBI to reduce the policy rate

RBI Watch                                                                                    Monetary Policy 2015-16

The August CPI inflation number should be out in another two weeks. If the number is below 4%, just like the July number, then I believe the RBI will seriously consider another 0.25% cut in the repo rate.

The RBI expects inflation to fall to 4% and then increase to 6% by January 2016. In this scenario, a repo rate of 7.25% is appropriate, given RBI’s real interest rule of 1.25 to 1.5%.

If however inflation consistently undershoots the 4% level, then the RBI will revise downwards its projected level of inflation for January 2016. Once this happens, the RBI will be open to another cut in the repo rate. A projection of inflation at 5.75% or lower by January 2016 will give room to cut the repo rate by another 25 basis points to 7%.

Let’s also look at the real economy at home and abroad.

Demand conditions continue to be weak. The latest GDP number for Q1 of 2015 at 7% suggests that there has been some deceleration in the economy, and the economy is unlikely to achieve the target of 8% GDP for 2015-16 set by the government. China’s economy continues to slow. Both the USA and Europe show signs of slow growth. The inflationary environment is exceptionally benign in most of the world. Commodity prices, including oil, have fallen sharply.

All this suggests that inflation, even if it trends up in the coming months, will remain benign and I expect the level to be below 6% in January 2016. Looking back, since September of last year, inflation has consistently held below the 6% level.

Yet, there are two sources of worry for the RBI: the potential for a China contagion and the imminent Federal Reserve’s move on the repo rate. Will the slowdown in China lead to financial market instability, and will this spread to India? Last week’s sharp fall in China’s equity markets rattled financial markets, although some semblance of stability returned by the end of the week. But let us be clear that the China uncertainty factor has a long way to go before it clears up.

Two, how will investors respond if the Federal Reserve decides to raise the federal funds rate at the FOMC meeting on September 16-17? Even if it does not, and my sense is that the Fed will not raise the repo rate at this meeting, it is only a matter of time before the Federal Reserve begins to normalise interest rates. Some adjustment on this front has already been made by investors and corporates, as the Fed had made its intentions clear for about a year. However, a combination of a possible China contagion and an increase in US interest rates may spook investors.

As these events unfold, the rupee could weaken sharply, there could be significant outflow of FX reserves, and money market conditions could tighten. As volatility increased in the financial markets last month, call money rates in India rose by 0.5%.

Despite these factors the RBI may still go ahead and reduce the repo rate in September, but future moves may be put on hold. The RBI could well justify this on the ground that banks have not fully passed on the RBI’s cuts in the repo rate (banks have reduced the base rate by about 0.3%, although the RBI has cut the repo rate by 0.75%), and that the RBI’s next move would come only when this has happened.

Monitoring the NaMo Bull Market in Stocks: Update as of August 2015

Indian Stock Market Watch

Please refer to my blog of July 9, 2014 for the original note on using TMV/GNP ratio to gauge whether the market  is cheap or expensive.