Ashima Goyal

The MPC will be walking on eggshells

Ashima Goyal | Updated on June 03, 2018

Crude impact The oil prices will weigh heavily on the MPC’s mind   -

The Monetary Policy Committee has to take a careful call on policy rates in a delicate situation, keeping an eye on growth

The long-run impact of higher crude oil prices and a weakening rupee on the current account and fiscal deficits depends on countervailing forces and actions. For example, although imports rise, so do value added oil exports as well as remittances. State value-added taxes that rise with prices should certainly be cut.

The Centre can also partially reduce excise on oil in a burden-sharing exercise. Since they did not fully pass on the earlier fall, they should now moderate any sustained rise. Tax buoyancy due to reform and improvement in growth together with economy in expenditure may help contain impact on the fiscal deficit.

Inflation impact

The effect on inflation depends on how persistent the oil price rise is. The pass through of oil price shocks has been falling as the economy diversifies. There is evidence that inflation targeting is able to anchor inflation expectations and limit second round effects.

There are countervailing forces globally also. OPEC is also worried that alternate sources of supply and renewable energy can get a further fillip, and that may be a reason it has agreed to reverse its cuts to compensate for shortfalls from Iran and Venezuela.

Oil prices whose hardening above $80 led to shock waves in the Indian media, softened to $76 on this news. Analysts expect it to soften further in 2019.

Effects of high real interest rates

On its structural reform path and under international pressure Indian macroeconomic policy has been squeezing demand ever since 2011 despite an industrial and investment slowdown. The real interest rate was kept above two per cent. The perverse effects of this are seen in the quick reappearance of macroeconomic vulnerabilities. Low growth makes it difficult to improve either the fiscal deficit, or exports or NPAs.

The RBI did not lower rates despite a sharp fall in food price inflation in 2016-17, sending the message that they want to be forward-looking and look through temporary commodity price fluctuations.

They should now be symmetric and look through sharp oil price fluctuations unless they become persistent and lead to second round effects.

The base effects raising inflation currently will be reversed. Interpreted as a minimum support price covering only variable costs, a rise in MSP will not be inflationary. The heavy duty in raising rural incomes must come from diversification and non-farm activity. The rise in agricultural growth suggests this is happening.

Some depreciation of the rupee is a useful correction for continuous appreciation since 2013. Research shows real appreciation significantly raises the current account deficit in India after a two- year period, and a rise in real interest rates depreciates the real exchange rate. Therefore an interest rate defense of the exchange rate must not be used. The taper-on tantrum of 2013 also showed that raising interest rates to reduce outflows did not work.

Many kinds of intervention, however, were successful in reducing excess volatility of the rupee. For example, the forex swap window for oil marketing companies that took their dollar demand off the market. Such intervention can, if necessary, provide a useful defense against too much depreciation spilling into a self-fulfilling cycle of outflows.

Foreign inflow push

Foreign inflows to India are driven more by its growth prospects. Given external shocks, a fledgling domestic demand and investment revival due to a fall in real interest rates needs to be protected, not snuffed out.

The disaggregated Q4 picture shows supply side improvements through investment and agricultural growth, while consumption and export demand remain weak.

A downward cycle can occur if monetary and regulatory policies are either too tight or too loose, so a balance is required.

If the MPC changes its stance from neutral to tightening, a series of rate rises would be priced in by the market. The high and volatile 10-year G-secs yield over the past year illustrates the ‘unpleasant monetarist arithmetic’: without monetary accommodation fiscal constraints can worsen causing perverse outcomes.

For example, liquidity was tight as the RBI sold G-secs to buy foreign securities and sterilise reserve accumulation. At the same time it reduced dispensations given to banks for capital loss on G-secs, just when interest rates were expected to rise inflicting such a capital loss. Demand for G-secs fell steeply, further raising G-sec yields.

Local demand and supply affect G-secs yields along with foreign interest rates, expected inflation and growth rates.

Rising interest payments that raise borrowings could further raise G-secs rates. Fiscal action, such as excise cuts, to reduce inflation becomes more difficult. Government interest payments as a ratio to GDP fell sharply from a peak of 4.6 in 2002-03 to 3.0 in 2010-11 but fluctuated around 3.1 in the low-growth high-interest rate period since 2011.

As inflows reduce or reverse, selling reserves but buying G-secs to replace US securities on the RBI balance sheet will reduce G-sec yields and market rates. Less FPI means more OMOs can take place within the target for long-term liquidity.

The temptation to invite more volatile types of inflows, and pay them more, must therefore be resisted.

Reviving banks

Prompt corrective action (PCA) is meant to help design a turnaround for a bank in trouble. More than a dozen banks under PCA together creates systemic spillovers rather than helping banks revive. Many small firms are being downgraded/driven to bankruptcy because they are not getting working capital.

Even so, there are healthy signs of diversification and alternative sources of funds in India’s financial sector. NBFCs and fintechs are able to give non-collateralised loans based on cash flows and other current big data. PSBs, however, will continue to be a major source of funds for SMEs. The government has made recapitalisation conditional on an expansion of Mudra loans. Since these are small denomination and diversified and tied to efforts to improve the risk-assessment capabilities they are less likely to create NPAs.

The latest round of NPAs is largely caused by RBI action scrapping all restructuring schemes and loading them all onto an untested and evolving IBC. The first large NPA (Bhushan Steel) has been resolved under the IBC but power plants cannot have the same type of resolution as steel mills. Assets under different types of restructuring were treated as standard and now had to be provided for.

Even so, the NPA problem seems to have finally peaked, with nothing left unaccounted for. The demand-led slowdown in credit growth that was adversely affecting NPAs has moderated, with the fall in real interest rates. Retail credit growth is boosting consumer durables. A demand revival will help strengthen bank balance sheets if the MPC refrains from choking it.

The writer is a part-time member of EAC-PM. The views are personal.

Published on June 03, 2018

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