By Invitation. Rate cut may not be the best solution

The Monetary Policy Committee (MPC) cut the repo rate by 25 basis points (bps) in the Third Policy Review for FY2018. Subsequent developments have thrown up certain policy conundrums.

The CPI inflation rate has risen rapidly and in a broad-based manner to 3.4 per cent in August 2017 from 1.5 per cent in June 2017. However, recent data on economic activity has been subdued, and the transitional challenges posed by the Goods and Services Tax (GST) have been more prolonged than what was initially anticipated.

With an uneven spread and modest deficit in monsoon rainfall, the First Advance Estimate of crop production has estimated a year-on-year (YoY) drop in output of most kharif crops, except sugarcane, which is likely to push up food inflation in the coming months.

The rise in prices of petrol and diesel and some lingering pass-through of the GST on final prices, remain risk factors. Moreover, the revision in HRA of the Central government employees would have a staggered impact on the housing index of the CPI, which is likely to push up housing inflation over the coming year. Based on these factors, the CPI inflation is expected to harden further, crossing 4 per cent by November 2017.

In addition to a modest pace of restocking of the domestic supply chain in July 2017, exporters are reporting stress as working capital requirements have ratcheted up. Hiccups related to GST filings, being articulated acutely by the SME sector, have also inordinately dampened sentiment. The realisation that economic growth has slid for five consecutive quarters has created the apprehension that a structural slowdown has set in.

In our view, the 7.9 per cent growth of gross value added (GVA), recorded during FY2016, reflected a temporary improvement in profitability, following the downturn in commodity prices, which is unlikely to recur in the ongoing fiscal.

The recent slowdown in volume growth is likely to prove transitory rather than structural in nature. For instance, the majority of the available volume-based indicators of the formal sector recorded an improved growth in August 2017 relative to the previous month, as the hiccups associated with the transition to the GST started to subside. Restocking prior to the festive season is expected to boost production further. Overall, domestic consumption is likely to remain the chief driver of economic growth in FY2018. However, a sustainable upturn in investment activity remains elusive, given the challenges faced by the corporate sector and SMEs, as well as Central and State governments.

Many Indian corporates remain highly leveraged, particularly in the infrastructure, construction, telecom and capital goods sectors. The moderate capacity utilisation, persistence of high leverage and availability of brownfield distressed assets are likely to constrain fresh corporate investment over the next year. The decline in the surplus to be transferred by the Reserve Bank of India to the Government of India (GoI), the ambitious targets for other communication services and disinvestment, and the low allocation for public sector bank recapitalisation, will limit the size of any fiscal stimulus that the GoI may announce in FY2018.

Moreover, a pick-up in state government spending on crop loan waivers, pay revision and the UDAY debt servicing will support consumption growth, but reduce the space for much-needed capital spending. If the current lack of clarity on the revenue buoyancy, post-GST, persists over the next couple of months, it may affect the Budget planning process for FY2019.

With the repo rate at 6.0 per cent and the CPI inflation expected to average 3.7 per cent in FY2018, lower than the medium-term target of 4.0 per cent, there may be room for further monetary easing. However, we do not expect an immediate rate cut, as inflation is expected to continue to rise and print between 4.5 and 5 per cent in March 2018. While an interest rate cut will provide some breathing room to corporates, it is unlikely to help jump-start investment activity in a meaningful manner.

In our view, a targeted programme of fiscal measures, such as raising extra budgetary resources through tax-free bonds to boost investment in roads, railways, metro rail and affordable housing, as well as policy intervention to address procedural concerns such as those being highlighted by exporters, may be more effective than a 25 bps rate cut.

The writer is Managing Director and Group CEO, ICRA

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