RBI risks monetary divergence, as it sticks to rates and stance

8 Apr 2022 , 01:24 PM

As the RBI governor concluded his speech, he coloured it with a leap of faith. Amidst the uncertain macro environment, the RBI governor quoted Mahatma Gandhi, “It is faith that steers steers us through stormy seas, faith that moves mountains and faith that jumps across the ocean”. Between the last policy meet in Feb-22 and the Apr-22 meet, the macro situation has become convoluted by 3 factors; Russia-Ukraine war, spike in oil prices and the relentless hawkishness of the Federal Reserve. The monetary policy was presented in this background by the RBI governor.

The April 2022 monetary policy was touted as one of the most important policies in the last 2 years. Over the last 2 years, the focus of the RBI monetary policy had been largely on boosting growth, even at the cost of higher inflation. April was supposed to be critical because the Fed has already raised rates by 25 bps in Mar-22 and has promised rate hikes in each of the remaining 6 FOMC meets. The onus was on the RBI; whether it would follow the hawkish global trend or take the risk of monetary divergence? But, first the highlights.

Highlights of the Monetary Policy — April 2022

• The repo rate held at 4%; reiterating the RBI’s commitment to keep rates low till durable growth returned, and even at the risk of monetary policy divergence
• Contrary to popular expectations of 15-50 bps hike in the reverse repo rate, the RBI opted to keep reverse repo rate static, and use VRRRs as an alternative
• The derived bank rate and Marginal Standing Facility (MSF) rate, as a result, stayed pegged at 4.25%, underlining RBI’s focus to keep lending rates low
• In the light of the negative macro cues coming from Ukraine and oil prices, RBI opted to reduce the FY23 GDP growth target by 60 basis points to 7.2%
• CPI inflation target for FY23 has been raised by 120 basis points to 5.7%, in line with higher crude oil prices and elevated levels of WPI inflation overall
• All 6 members of the MPC unanimously voted to hold repo rates at 4% to support the economic recovery, even in a worst case scenario
• All 6 members of the MPC also voted unanimously to keep the monetary stance accommodative, with Jayanth Varma also casting his vote in favour

FY23 GDP growth cut from 7.8% to 7.2%

In line with the overall downgrades in GDP growth for FY23, the RBI has also cut the growth estimates for FY23 by 60 bps from 7.8% projected in Feb-22 to 7.2%. This is to reflect the likely impact of the Russia-Ukraine war, the surge in oil prices, rampant commodity inflation and the relentless hawkish stance of the US Federal Reserve. However, there are some positives too. The strong Rabi prospects are expected to improve rural demand. Also, the revival in contact intensive industries like hotels, trade, transport and tourism is likely to aid the economy recovery in the coming quarters.

The 60 bps lowering of the FY23 GDP estimates is due to continued supply chain constraints resulting in weaker export growth and lower global demand for Indian products and services. RBI is also factoring in the negative rub-off effects of ultra-hawkish policies by the developed world. Along with reducing FY23 GDP growth estimates by 60 bps to 7.2%, RBI has also back-ended significant impact on growth. GDP growth for FY23 is expected at 16.2% in Q1, 6.2% in Q2, 4.1% in Q3 and 4.0% in Q4. RBI sees risks to growth as broadly balanced.

Data Source: RBI Monetary Policy Statement

RBI raises FY23 inflation estimate from 4.5% to 5.7%

Since the Feb-22 policy, a lot has changed at a macro level. Oil crossed $120/bbl, although it has tapered since. Commodity inflation is still rampant and the relentless US hawkishness points to continued rise in US inflation even beyond 8%. In this light, the Feb-22 inflation estimate of 4.5% was too conservative and has now been raised by 120 bps to 5.7%.

RBI sees 2 major areas of concerns on the inflation front. Firstly, the uncertain geopolitical situation in Ukraine is a major overhang. Secondly, the global cycle of inflation in food products could negate most of the food price control that the government is attempting through supply side tweaks. Inflation outlook for FY23 has been raised by 120 bps to 5.7% with a lot of front-ending of inflation risk. For FY23, RBI has broken up the 5.7% full-year inflation into Q1-FY23 at 6.3%, Q2-FY23 at 5.8%, Q3-FY23 at 5.4% and Q4-FY23 at 5.1%.

Development and regulatory measures announced by RBI

In the last few policies, RBI has made a lot of key announcements outside the policy statement and as part of regulatory measures. Here is a gist.

a) RBI is terminating fixed rate repo rate floor, which will be replaced with the standing deposit facility (SDF) carrying an interest rate of 3.75%. The idea is to use the FRRR and the SDF jointly for the RBI liquidity management.

b) The special scheme for individual home loans, wherein the risk weights were linked to the loan-to-value (LTV), is valid till March 2022. Now this scheme with the risk weight flexibility has been extended by one more year till March 2023.

c) RBI plans to make cardless cash withdrawal permissible across bank ATMs in a seamless manner. It is proposed to enable customer authorization via UPI matrix while transacting at bank ATMs. This will reduce the risks of skimming, fraud, card theft etc.

d) RBI to appoint a committee to review customer service standards of all RBI regulated entities. This will including putting in place the Ombudsman framework for overarching protection for customers. This is more relevant with advent of digital products.

It is rather surprising that the RBI has opted to maintain status quo on rates and sustain its accommodative monetary stance. With the US to hike rates by 200 bps in 2022 and unwind $95 billion of bonds each month, the RBI cannot overlook the risk of monetary divergence. As we have seen in the past, capital flows and run on currencies can escalate quite fast. Hopefully, the RBI-MPC has a Plan-B in place to tackle such eventualities.