RBI should hold rate steady even if Budget 2015 is good

The expectation of further rate cut from RBI is almost universal now. Most market participants differ only on the amount of rate cut they expect in 2015-16, which varies from 25 basis points to 100 basis points.

However a less likely, though not remote, scenario exists where the RBI may not make any further reduction in policy rates until March 2016.

The genesis of this argument lies in two streams of thought. One from Chief Economic Adviser (CEA) and certain industry leaders and second from the RBI policy statements itself.

Public spending key to growth revival: Sometime back Arvind Subramanian (CEA), while expressing confidence on the government’s ability to meet the fiscal deficit target for FY15, also highlighted the need of public sector spending for reviving growth.

Several business leaders as well as market analysts have also been harbouring such beliefs. Needless to say that if in FY16 or FY17 the government finally decides to go for the public spending push, then the target of reducing fiscal deficit to 3% of GDP in 2016-17 is likely to be missed.

The possible slippage in fiscal consolidation target may potentially weaken the Indian rupee if and when such government spending is resorted to. In fact, if the rupee depreciates significantly any potential benefit from the government spending may be lost. In such a scenario, the government would have to bank on the RBI to stabilise the currency to the extent possible.

As such given the decade-high leverage level of Indian corporates and low capacity utilisation, it may be argued that most members of India Inc are in no shape to revive the economy through a heavy duty investment drive.

Thus even if the RBI reduces interest rate further and Indian banks, showing uncharacteristic benevolence, pass on the interest rate cuts immediately, one can’t expect a meaningful revival in growth. At best, it can only offer the over-leveraged corporates some breathing space.

The government is relatively better placed to drive the infrastructure spending in the short to medium term and possibly presents the best case scenario of reviving growth.

Real interest rate cushion: Yesterday’s (3 February) monetary policy document states that “key to further easing are data that confirm continuing disinflationary pressures. Also critical would be sustained high quality fiscal consolidation…."

This has led market participants, in general, to expect that if inflation is under control and if the Union Budget on 28 February 2015 keeps to the stated path of fiscal consolidation then the RBI will ease interest rate further. The RBI may as well take the course.

However, my argument is that if the central bank keeps on reducing interest rate further, it will rob itself the opportunity to support the government’s likely public spending strategy to revive the economy.

To explain the argument further, the real policy interest rate (in Mid-Year Economic Policy Analysis 2014-15 published by the Ministry of Finance) currently is slightly above 2%, a level last seen in 2007. Real interest rate is the nominal interest rate adjusted for inflation.

As per the most recent data available with the World Bank, the real interest rate in India is well over 3%, which is a four-year high. Of course, it is well below 6.3% which was the average real interest rate in India for the period 2001 to 2008.

As such, a solid real interest rate adds to the attractiveness of a currency and to an extent provides some shield against the currency’s depreciation.

If RBI keeps on reducing interest rate in tandem with the expected inflation trajectory, the real interest is likely to remain range bound between 3% and 4%. Under such a scenario, if the fiscal target is missed then the market may react adversely causing the rupee to depreciate.

On the contrary, if RBI holds onto interest rates or applies only very limited rate cuts then real interest rate cushion is likely to increase, subject to inflation remaining low.

This build-up of real interest rate will allow the government to go for significant public spending, in the belief that any adverse sentiment triggered by the breach of the stated fiscal deficit target may be reasonably mitigated by the real interest rate cushion.

The author is senior director - corporate ratings, India Ratings & Research. Views are personal.