DID THE RBI CUT TOO LESS

D

The stock markets reaction subsequent to the Monetary Policy Committee rate decision last Friday indicated disappointment with the decision to cut by “Just 25 basis points”. Market expectations had started running high after the RBI Governor just a few days back had indicated strong support for the economy. However in my view 25 basis points was sufficient in view of their cuts over the last many months. The main issue is with the transmission and that is where RBI has failed.

From a peak of 6.5% at the end of last year the Repo Rate has come down to 5.15% a significant easing we would think . This has also been accompanied by RBI ensuring that the liquidity in the system is surplus. However the monetary transmission has got impacted due to market distortions caused by first the issues with DHFL, then the Yes Bank saga and now questions around the Indiabulls Group. This has been accompanied by the infamous developments in Mutual Funds where several promoters who pledged shares with them could not pay back on time and writedowns by MF’s also created risk aversion.

The ill founded increase in Repo Rate which the Urjit Patel and Viral Acharya duo promoted at the time when the ILFS issue came up last year is one of the major reasons why an already stressed economy got further crushed as the rate hikes came just before the festival season last year and that combined with various other factors and the RBI keeping the system in deficit ensured that liquidity completely dried up by the end of last year. This further increased the stress in the system and in segments like real estate which was already going through a tough period. As stress further grew on the Real Estate segment, many that had lent to this segment started coming under stress. Builders with incomplete projects, even those who had the intention to complete projects saw funds totally dry up and started off a vicious cycle in the market.

Although the RBI under the new governor started on a rate cutting cycle and started moving the system into surplus liquidity it has been a slow process and in the middle of this we had the election period where demand further contracted and the economy went into a freeze.

Monetary policy always acts with a lag and as such we will definitely see the impact of rate cuts going forward. The mistake that RBI is making is that they are not taking steps to reduce the spreads in the market. Although liquidity is in surplus they need to take it much more into surplus so that it goes into such deep surplus that market rates start responding and start coming down. One of the reasons why rates fall slowly is also due to the Small Savings rates being still kept too high due to political reasons. Hopefully these will also come off going forward.

The MPC has continuously overestimated both inflation and growth on a continuous basis over the last three years and this had led them to take suboptimal decisions. This is reflected in the following data

RBI/MPC Inflation forecast, 6 months hence

Aug 2016 5% Actual 3.9%

Feb 2017 4.5% Actual 2.2%

Apr 2018 5% Actual 2.5%

Aug 2018 5% Actual 3.2%

Feb 2019 3.9% Actual 3.2%

Given the global growth outlook and commodity prices it is unlikely that there will be significant drivers of high inflation anytime soon. An above normal monsoon will also ensure that food prices are in control over the next one year. Ideally we should see the MPC move rates further down by 50 to 75 basis points by the end of this financial year. This combined with government initiatives will see a significant growth revival going forward.

In a nutshell I do not believe that the decision of Friday was wrong. However the speed of decision making in the past and last years unfounded rate hikes plus NBFC issues have distorted the markets. RBI need to push more durable liquidity into the system which they are reluctant to do.

Stock Markets have given up 50% of the gains after the corporate rate cuts. Several reform measures including Strategic Disinvestments have already been announced. I wouldn’t be over pessimistic on the markets. Directionally things are looking much better.

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