“The headroom for further monetary easing remains quite limited” was enough for the Sensex and Nifty to fall by over 1.5 percent and for the 8.15 percent 2022 government bond yield to rise by 6 bps (100 bps make 1 percent).
The markets are reading the Reserve Bank of India (RBI) statement as no rate cuts going forward unless there is a fall in food inflation that is trending at 11.4 percent levels.
The RBI is spooking the markets with its focus on food inflation at a time when non-food manufacturing inflation is trending at multi-year lows of 3.8 percent levels while GDP growth for fiscal 2012-13 is expected at decade lows of 5 percent.
The RBI feels it has done enough for the present to address growth issues. The central bank has cut repo rates by 100 bps and CRR by 75 bps in fiscal 2012-13 and it has bought government bonds of around Rs 1,60,000 crore (equivalent to 250 bps of CRR cuts). It is now indicating that it will wait and watch for further signs of growth slowdown to take action on policy rates.
The RBI guidance of no rate cuts in its 3 May 2013 annual policy is not positive. Banks will have no inclination to lower lending rates at a time when there is continuous stress on assets due to a weakening economy. Banks will not strive for credit growth given that the reduction in non-performing assets (NPAs) will be the priority. Banks will buy government bonds, as it will be seen as a safe asset in times of stressed balance-sheets. Banks NPAs have risen by 50 percent in the first nine months of this fiscal, reflecting the stress on balance-sheets due to the economic slowdown.
The government benefits from banks buying government bonds as it can push through borrowing of Rs 579,000 crore in fiscal 2013-14. However banks buying government bonds will not help the economy in any way unless government bond yields trend down to levels where banks find it more worthwhile to lend to the economy. In short banks have to be discouraged from buying government bonds and that will not happen unless government bond yields fall, economic growth improves and banks become more comfortable on credit.
The RBI’s hawkish tone on further rate cuts suggest that government bond yields will not fall as markets will be reluctant to fund the government at lower levels of yields. Economic growth will not happen as lending rates stay high in the economy while banks will continue to shy away from credit exposures on NPA worries.
The question the RBI will now have to ask itself is: “what purpose will a status quo on policy rates achieve?” If the answer is that it will contain inflationary expectations leading to a fundamentally stronger economy that can in turn lead to sustainable economic growth, then it is best to keep rates on hold. On the other hand, if no rate cuts lead to inflation expectations remaining high and economic growth falling off a cliff, then rates should either be pushed up or lowered. Doing nothing does not help.
In the meanwhile markets will have created enough volatility to hurt sentiments on the economy. Until 3 May 2013, Amen.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.