With US Fed uncertainty resolved, should RBI go for out-of-turn rate cut?

The Reserve Bank of India, the Government and India’s lucky stars which caused commodity prices including crude to correct sharply may be thanked for improving the fiscal situation as well as external finances. This strength allowed India to handle the ‘China scare’ in July 2015, than most emerging markets (EM). [caption id=“attachment_2548910” align=“alignleft” width=“380”]  Reuters[/caption] For this, the RBI had to spend just $2.59 billion from its forex reserves. In comparison, during taper tantrum, the RBI has to spend forex reserves to the tune of $21 billion between May and September 2013 and still the rupee depreciated by 20 percent. Thus far, justifiably, the RBI has cited the possible spill over effects of US Fed rate hike decision, as among the reasons for not giving in to the clamours for rate cut. To explain , there was a wide spread concern that when the US Fed increases the interest rate a lot of foreign investment would move out of EM. This will cause EM currencies, including the rupee to depreciate sharply as observed during the taper tantrum of 2013. When a currency sharply depreciates its central bank tends to increase the domestic interest rate so as to make its currency more attractive to foreigners. A case in point is Russia, which during December 2014 had to increase its domestic policy interest rate drastically from 10.5 percent to 17 percent in order to check rouble depreciation. Clearly the risk of a significant spill-over effect does not seem to be there for the rupee and even in the unlikely situation that happens the RBI reserves are in all likelihood sufficient to handle the situation. As of 4 December 2015, the RBI’s forex reserves stood at a healthy $352 billion. Even if the rupee shows significant weakness it is more likely to be temporary and is unlikely to breach 69-70 level against the US dollar for a sustained period in the short term. Even in an extreme scenario the RBI has to spent say an exceedingly high amount of $40 billion, still the reserve that will remain will be a very reassuring $310 billion - an amount equivalent to over 10 months of net import. Beware of deceptive ‘recovery’ The 7.4% GDP real growth (i.e. the GDP growth adjusted for economy wide inflation) for Q2 2015-16 may give the impression that the economy is on recovery track considering the growth in the previous quarter was 7.1 percent. However the nominal GDP growth, which is unadjusted for inflation has grown at 8.8 percent (Q1 FY16) and 6 percent (Q2 FY16). The economy wide inflation measure - GDP deflator - has actually fallen below 0 and was at -1.4% for Q2 FY16. This may be tell-tale signals that the economy may be slipping into a deflation. The historic low corporate growth rate (which is currently the worst in a decade) is testimony to the fact. Clearly this calls for RBI action. RBI may look at deflation The RBI has adopted the recommendation of Urjit Patel Committee Report, which says the RBI will focus on CPI as a measure of inflation in its monetary policy decisions. The period of analysis that was used during the Urjit Patel committee’s research did not throw up such a long period, where the GDP deflator diverged so significantly from CPI. However, GDP deflator is on a downward trajectory and is at -1.4% while CPI remains around 5%. If the RBI continues to focus exclusively on CPI and neglects the GDP deflator then it may not decide to reduce the interest rate. With a GDP deflator at -1.4% in the previous quarter and overall around 0.4% in first half of FY16, the current real interest rate in India is possibly close to 8%. The real interest rate is the interest rate prevailing in the economy minus the GDP deflator. Such a high level of real interest rate is detrimental of economic revival. In fact, such a level has not been observed since 2002 Of course, relatively, higher real interest rate (in comparison to other comparable countries) or a trend of improving real interest rate in an economy tends to add to the attractiveness of that currency. But for this purpose, as may be empirically observed for India’s a real interest rate of 6 percent or thereabout appears sufficient. This means that with US Fed rate hike uncertainty behind it and likelihood of severe spill-over effect limited, RBI has the elbow room to cut interest rate by 200 basis points. Else if RBI does not reduce interest rate citing CPI, then Indian economy may follow a glide path to deflation. The author is a visiting faculty at IIM Calcutta and a financial services professional