We expect the RBI’s Monetary Policy Committee (MPC) to raise policy rates by 25 basis points (bps) on June 8, to fight inflation and offset Fed hikes. He is also expected to shift the monetary policy stance from neutral to accommodative, with Governor Das already prioritizing inflation over growth. Going forward, the MPC is expected to increase the repo rate by an additional 75 basis points by April 2023. Second, we expect it to raise banks’ HTM limits by 1% of the portfolio and expand the upper HTM limit in FY26. Finally, the RBI is likely to raise the FCNRB deposit rate cap against Libor by 50 basis points to attract NRI deposit flows to increase foreign exchange reserves.
The RBI MPC is expected to raise the repo rate by 25 basis points on June 8, August, October and April. This will cause the terminal repo rate, at 5.4%, to approach India’s growth by maximizing the inflation threshold of 5.5-6%. While we were against the grain in calling for a rate hike in April policy, this time we are below consensus by 50 basis points. As the RBI has already hiked policy rates by 80 basis points since April, we expect it to moderate the pace of tightening given the weak recovery. This will likely reduce the real GDP growth forecast for FY23 by 20 basis points to 7%. We see real GDP growth slowing to 6.7% in FY23 and 5.5% in FY24 due to a demand issue in the country and a slowdown induced by the Fed abroad. We estimate that a US recession costs 100 basis points of Indian GDP.
This begs the question, why do we now prefer a slower pace of RBI rate hikes than the street? Lending rates on loans granted to micro and small industries (MSI) by banks in the priority sector are now linked to the policy rate. This was originally done to quickly reduce their borrowing costs. Paradoxically, increases in repo rates will first affect MSIs. It is for this reason that we expect the Ministry of Finance to provide a 1% subsidy on bank loans to MSIs at a negligible fiscal cost of ₹$130 billion/$1.7 billion (0.05% of GDP in FY23-24). Since monetary policy impacts inflation with a lag, it’s hardly as if an RBI rate hike of 50 basis points would act noticeably faster than, say, 25 basis point hikes in two consecutive political meetings.
That said, we emphasize that the RBI MPC cannot sustain significant negative real rates any longer without fueling future inflation. Granted, we see inflation peaking at 7% in May and at 6.3% for FY23, from 7.8% in April. Yet this is not only above the RBI’s 2-6% inflation target, but also above the inflation threshold. The RBI MPC will likely raise its inflation forecast for FY23 by 80 basis points to 6.5%.
A big relief is that the fundamentals driving inflation are still fairly benign. A shallow rally limits pricing power. Second, a good monsoon (103% of normal predicted by the India Met) should alleviate agflation. Third, increases in the RBI’s cash reserve ratio (CRR) helped contain money supply (M3) growth (9.5% vs. 11.1% a year ago). Fourth, the recent reduction in government excise duties (petrol by ₹8/litre and diesel per ₹6/litre) and other measures are easing pressure from rising commodity prices. Fifth, Fed tightening should also dampen commodity price inflation. Finally, the high foreign exchange reserves support the rupee to reduce the risks of “imported” inflation.
The RBI will also be pushed for further tightening by the Fed. We expect further hikes of 175 basis points in 2022. As it stands, the spread between the RBI repo rate and the fed funds rate at 365 basis points has fallen below average to medium term of 500 basis points. Although we do not believe it necessary to increase the spread given the high foreign exchange reserves, it is certainly not possible to compress it below the terminal spread of 240 basis points that we project. We see the INR trading at ₹The 77/USD levels are now tied to unfavorable trade seasonality, outflows from the REIT on a strong US dollar due to Fed tightening and high oil prices. When these factors reverse, it should appreciate again ₹76/USD by March.
The yield on 10-year government bonds is expected to peak at 7.75% by March 2023 due to the tightening RBI and a high budget deficit. A relief is that RBI FX sales ($58 billion by our estimate) and CRR hikes will expand RBI’s ability to buy gilts on the open market (eg $69 billion) to fund the deficit. high budget.
The author is head of India Research, CLSA. Views are personal.