RBI's Dilemma On Future Rate Actions: Follow Domestic Or Global Cues

The Monetary Policy Committee of the Reserve Bank of India increased the benchmark repo rate by 50 basis points to 5.90% with a 5-1 majority. This is the fourth consecutive rate hike in as many months this year. While the rate hike was in line with wider market expectations, the policy announcement was much waited for the RBI’s commentary on its stance and future actions, given the policy action and future guidance by global central banks in advanced economies. With guidance of peak policy rates at over 4.5% by U.S. Federal Reserve, spike in bond yields in developed economies and subsequent depreciation of Indian rupee, there were uncertainties on the RBI’s own policy stance on interest rates in such a gloomy global backdrop.

The commentary from the RBI, however, seemed to be confident about their future policy actions, which will be driven by local considerations, as the local inflationary conditions are not as alarming as the case in some major advanced economies. The RBI retained its inflation projection of 6.7% for FY2023 and expects it to be 5.0% in Q1FY2024, though there was a downward revision in growth estimate to 7.0% for FY2023 as against the previous estimate of 7.2%.

The stock and bond markets have reacted positively with the Sensex rising 2.25%, and yield on 10-year G-sec remaining unchanged at 7.36% despite a hike in policy rates.

The RBI continued to maintain its policy stance of “withdrawal of accommodation”, given the inflation levels remain higher than policy rates amid sizeable durable liquidity (including large cash balances of Government of India–GoI). As the GoI spending picks up in coming months, the liquidity in the banking system could ease ensuring the availability of funds for credit growth. In our view, a likely drop in inflation readings in H2 FY2023 suggest that the MPC may temper the rate hikes going ahead, even if the U.S. Federal Reserve and other major central Banks continue with aggressive tightening till their CPI readings fall to acceptable levels.

With the hike in repo rates, the loans linked to the external benchmarks like Treasury bill rates are going to be costlier. Moreover, as we enter busy season for the credit growth and it picks up further, the banks will need to raise resources by hiking deposit rates, which mean further hike in cost of funds for the borrowers. The hike in retail deposit rates has lagged the wholesale deposit rates in recent months and the differential seems to be as high as 130-150 basis points between a one-year wholesale and retail deposits. We expect this differential to narrow as the retail deposit rates could start getting repriced upwards at a faster pace hereon. Having said that, the increases in the small savings rates for Q3 FY2023 were limited to certain instruments, and more modest than what we had expected.

The RBI’s continued focus on strengthening the financial sector is seen in the announcement of the discussion papers on expected credit loss-based provisioning approach for banks and the securitisation of stressed assets framework. While we await the fine print, we believe the banks are well positioned to take the incremental hit, if any, on their capital because of increase in provisions requirement on their loans upon transitioning to IND-AS. As the provision cover on non-performing loans is relatively high, the incremental provisioning requirement will be driven by their standard restructured as well as overdue loans. Similarly, the discussion paper on securitisation of stressed loans may evince interest from more market participants thereby widening the investor base for direct purchases of these stressed loans from banks and lead to better price discovery for banks.

After the pandemic and challenges posed by Russia-Ukraine conflict, the policy rate actions by major central banks emerge as a key macro-economic challenge. While India is much better placed in terms of growth outlook, inflation trends and forex reserves, we will have to remain watchful of global developments. The RBI may effect one more small rate hike in the current fiscal as tightness in global liquidity and risk aversion have led to tighter financial conditions domestically. Given an improving domestic growth outlook, hopefully we shall navigate well in the turbulent times ahead.

Karthik Srinivasan is senior vice president, group head-financial sector ratings at ICRA

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