Rajan will continue inflation war: Why lending rates will remain high

In the end, it turned out to be a fine balancing act by the new Reserve Bank of India (RBI) governor Raghuram Rajan in dealing with the current economic situation following the breather provided to him by the US Fed’s decision to postpone tapering of the stimulus program.

Rajan gave a clear signal to the financial system by his twin acts of reducing the Marginal Standing Facility (MSF) rate - the rate at which banks borrow overnight funds from RBI - by 75 basis points while, on the other hand, increasing the benchmark LAF repo rate - the rate at which the central bank lends short-term funds to banks - by 25 basis points.

The first action provides some relief to the banking system by reducing its immediate cost of funds and, together with the relaxation of the daily cash reserve ratio (CRR) maintenance limit to 95 percent from 99 percent, gives back some much-needed liquidity into the system.

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However, for the medium term, Rajan has made it clear that there is no question of lowering the guard against inflation, which is the prime enemy for the central bank and can derail any effort to get the growth momentum back. A close look at Rajan’s tone and the language of the policy statement makes is abundantly clear that while the MSF measure is a temporary one to ease the banks’ burden, the longer term war RBI is fighting against rising prices continues unabated.

In fact, Rajan is unambiguous in saying that if the situation so warrants, the emergency measures to cushion the rupee’s fall, which were partially rolled back, could be used again and that would not require a policy date to be done. “We remain vigilant about external market conditions and will do what is necessary if they deteriorate once again,” the RBI governor said while explaining the details of the policy actions on 20 September.

The most important point to note, however, is this: the RBI has used the stabilization of the rupee to withdraw the emergency measures, but has by no means lost sight of the ball as far as the medium term is concerned, particularly given the turbulence witnessed in the currency markets a few weeks ago when the mere talk of the Fed’s tapering of stimulus drove shivers down the collective spine of jittery currency markets. Moreover, with inflation as evidenced by WPI (6.1 percent) and CPI (9.5 percent) coming in on the higher side once again, RBI sees no room for complacency.

Another 50 bps repo hike by Dec?

The clearest comment from Rajan was that the difference between the MSF rate and the LAF repo rate would be brought down to 100 basis points from the 200 basis points after the 20 September policy actions (MSF at 9.5 percent and LAF repo 7.5 percent). With inflation continuing to be a serious threat and structural bottlenecks hardly out of the way, the bets are more on RBI using the repo rate once again as the chief monetary policy tool and using that to reduce the gap between MSF and repo.

According to a post-policy report by Kotak Mahindra Bank: “The RBI clearly indicated that the repo rate and MSF rate corridor will be normalized to 100 bps. However, it is unlikely to be with MSF rate reduction alone. Upside risks to inflation are high with the RBI indicating that the actual WPI inflation will be higher than end-FY2014 projection of 6 percent. Our estimates indicate that depending on quantum of the diesel price hikes, headline WPI inflation is likely to be in a range of 7-8 percent factoring in food inflation and import-led inflation. Hence, we think that there is a realistic chance of the repo rate to move higher by 50 bps by end-CY2013 to 8 percent. MSF rate can simultaneously be lowered to 9 percent for a corridor of 100 bps.”

Adds Standard Chartered Bank: “..With an uptick in WPI inflation, still elevated CPI inflation, and the risk of fiscal slippage, the RBI has shifted focus back to domestic factors. Indeed, the RBI has prepared the market for possible policy actions outside the scheduled policy meetings, if needed.”

Rajan, who has emphasized more than once on clear communication of a central bank’s actions for best results, also explained the dual objectives of his policy after the review was unveiled. “The intent here is that when the repo rate becomes the effective policy rate, it should be consistent with inflationary conditions in the economy. On net, these measures will reduce the cost of bank financing substantially while allowing us to take an appropriately precautionary stance on inflation.”

More importantly, RBI realizes that turbulence in the currency markets may have reduced for now, but with tapering inevitable, it was important that the time available was created to quickly put together a ‘bullet proof national balance sheet and growth agenda.’

To that end, the recent RBI moves on FCNR(B) and currency swaps had already brought in a healthy $1.4 billion and more steps would be taken to shore up defences in the time available.

Lending rates to remain high

While the MSF has been lowered, the resultant savings are not expected to lead to any lowering of lending rates by banks. Consequently, lending rates will stay elevated for now. CRISIL also points to this, saying: “With a 25 bps increase in the repo rate and a 75 bps decline in the MSF rate, banks will witness a marginal decline in their cost of borrowings. However, the resultant saving will not be sufficient for banks to lower their lending rates. We thus expect lending rates to remain elevated.”

According to CRISIL, with a rise in the cost of short-term funds, rising delinquencies and increased competition, net interest margins (NIMs) will remain under pressure, especially for public sector banks. Average NIMs are thus expected to decline by 20-25 bps during 2013-14.

Raghuram Rajan remains a hawk for the medium term. That may not be very good for the powers that be in New Delhi, but that is unlikely to be the priority for the central bank governor who just proved to the world that his independence as the boss of the RBI is beyond doubt.