BANKING

To cut or not to cut-RBI's monetary policy dilemma

rbi-bankruptcy-file-pti A few bankers and fund houses expect the RBI to go aggressive and cut 50 bps, in response to domestic factors such as decelerating inflation and de-growth in credit offtake | File

There is a general consensus among market observers as well as D-Street analysts on a 25-bps rate cut

Markets, fund houses and corporate India are eagerly awaiting the Reserve Bank of India (RBI) monetary policy committee's meeting tomorrow. While there is a general consensus among market observers as well as D-Street analysts on a 25-bps rate cut, the RBI could offer a mild surprise. 

Some bankers and fund houses expect the RBI to go aggressive and cut 50 bps, in response to domestic factors such as decelerating inflation (which is alarmingly low and closer to deflationary threat) and de-growth in credit offtake. With real interest rates being already high in India, an aggressive rate cut might give banks an opportunity to reap some extra profit from bond holdings providing a boost to credit offtake. 

In light of the non-performing assets, banks have tremendous financial pressure to lend with sizable cash in hand. Credit offtake is the lowest in 20 years, a worrisome sign, and may prompt the RBI to cut at least 25 bps. Soft inflation, booming equities, promising monsoon and high expectations of rate cut to jumpstart investment cycle and prevent credit de-growth might inspire the RBI to go for a cut. 

Another compulsion can be backdoor recapitalisation. In view of the high NPAs, banks are obviously reluctant for fresh lending. With enough cash in hand, a rate cut that will drive down bond yields would offer lucrative bond trading opportunity to banks. 

At the same time, an opposite school believes that chances of 25 bps rate cut is likely and seems to be factored into the current Bank Nifty valuations. 

However, the RBI may choose to play super safe and keep rates unchanged. Domestic conditions are too tempting and compulsive to go for a cut; however, external environment is highly challenging for the RBI. 

There seems to be a rising decoupling between global interest rates. Central bankers are no more in a harmony and in agreement. The US Federal Reserve is now in broader tightening mode. The Fed has already hiked rates four times—100 bps in the past two years. Soon, it might start unwinding its mammoth balance sheet, which would mean that the Fed would sell bonds and suck extra liquidity out of system. 

There is a paradigm shift in Fed's monetary policy. Having achieved inflation target and full employment, the Fed has shifted its current focus to control asset bubble risk. 

Taking cue from the monetary stance of the Fed and its domestic scenario, the European Central Bank—also in a taper tantrum—might go for bond tapering. A rate hike could come as early as the first quarter of 2018. 

The Bank of England is also a little hawkish. Recently, Canada had hiked rates—first such hike in the last seven years. China is also on a gradual tightening mode to control asset bubbles and to defuse systemic risk linked to shadow banking. Deflation threat in developed world is over for now. Currently, tail-end risks shift in favour of inflation—certainly not a welcome news for emerging markets. 

Commodities are bottomed out and resources like iron ore, steel and coal prices are up, these have nearly doubled in the last three years. Metals and crude prices are up by almost 50 per cent in the last 15 months. Commodity inflation, usually having a lagging effect, may soon reflect in producer prices—the wholesale numbers. Global manufacturing PMIs are no more contracting. Equities in developed markets look lofty and asset bubble risks are in elevated mode. 

Given the material tightening in the US and monetary tightening in several other economic zones, there is a remote possibility that the RBI might opt for status quo. In such a scenario, the markets may overreact towards the downside, albeit temporary. In the current situation, if evaluated in totality and not in isolation, odds are equal for a cut and for status quo. 

The RBI is still in a little dilemma due to conflict between domestic and global macros. To conclude, we envisage two equally probable scenario. A modest rate cut with mild hawkishness or status quo with mild dovishness. However, chances of 50-bps cut seems unlikely. 

(Author is founder and CEO, Paradigm Commodity Advisors Pvt Ltd)

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