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RBI could go for OMO in second half of FY19: Sonal Varma, Nomura Financial Advisory

Currency leakage as well as the balance of payment position,..

Currency leakage as well as the balance of payment position, suggest that banking system liquidity will move into a deficit and therefore OMO buyback will need to be done by RBI to ensure that the weighted average call rate remains close to the policy rate, Sonal Varma, India Chief Economist, Nomura Financial Advisory, explains to ET Now.

Edited excerpts:
The optimistic in me is prompting me to ignore the rate hike and focus on the growth commentary. Is that the right way of looking at yesterdays policy?

Everybody is going to look at and analyse the policy from a different perspective. Clearly the macro setting has changed, we have moved forward to a macro environment where both growth and inflation numbers are picking up.

Even on the global front, certain risks have emerged — whether it is from higher oil prices or the fact that the dollar has been a bit stronger which has led to capital outflows from some of the emerging markets. US yields have moved higher. So, both domestic as well as the global macro environment has changed and that is what the monetary policy yesterday acknowledged by hiking the repo rate.

What is the outside chance because equity markets are already pricing that in that there are going to be perhaps two or three more rate hikes coming in. Do you think that is the right approach?

Our takeaway is that this is not it. There will be some more tightening — 25, 50 or 75 bps. One thing that did surprise us was the stance which was kept at neutral. If the MPC wanted to signal a 50 or75 bps rate hikes even after the hike delivered yesterday, then the stance should have changed to tightening. Actually, our interpretation is a bit different. The MPC, at least for now, does not see the need to signal that there are significant rate hikes coming in. They are a lot more data dependent but yes, if the growth inflation numbers are headed higher in the next few months, we think that the RBI will follow through with another hike in August.

Beyond this, it is going to be a function of whether the current growth cycle sustains or not. Let us not forget that market interest rates moved higher much before the Reserve Bank raised the rates and therefore some tightening of financial conditions happened.

Oil prices moving up for a consumer economy like India is a negative in term of trade shock. So, how sustainable the growth cycle domestically is in India and whether the global macro environment stays as it is right now, improves or worsens, those factors will determine the policy action beyond August.

Are you disappointed that there was not much clarity on liquidity? One was hoping that there would be some announcement coming in. How do you think RBI will tackle the liquidity situation from here onwards?

There was some expectation that given the rise in long-term bond yields, there would be some sort of a commitment on open market bond purchases but to be fair, that is really a function of two primary factors; one is how the balance of payment position pans out because unlike last year, India is going to run a very small balance of payments surplus, if at all. In fact, it could be a balance of payment deficit. So, if there is FX intervention in terms of selling dollar, then the Reserve Bank actually may need to inject more INR liquidity.

Second, the increase in currency in circulation has been quite substantial in the last one year and post August-September, we will again see significant currency outflow from the banking system. Both these factors; the currency leakage as well as the balance of payment position, in any case suggests that banking system liquidity will move into a deficit which is sort of a permanent liquidity getting into a deficit and therefore some amount of OMO buyback will need to be done by the Reserve Bank of India to ensure what they mentioned yesterday which is that the weighted average call rate remains close to the policy rate.

So, although the commitment did not come yesterday, but effectively given the macro dynamics we do think that OMO buyback will happen in the second half of FY19.

How much do you think would two or maybe three rate hikes impact the revival in investment demand led growth which the government has been banking on for a while and draw out a correlation because one is still not clear how sensitive that demand revival in loans is to a tightening cycle?

That is a fair point and even if you look at the break up of credit, it is not that industrial credit is picking up, a lot of the increase we have seen is really on the retail side. What the higher interest rates do is, to an extent they try to curb down that part of consumption demand which is being driven by increased credit expansion.

So, there might be more of an impact on that front in terms of retail credit. At this stage, given the balance sheet situation, neither were rate cuts going to significantly reive private investments nor will they lead to delay in the same vein because the focus is on balance sheet deleveraging right now.

The channel of impact is primarily on the consumption side to an extent and second, from the signalling perspective, it is more than the policy rate. Clearly, the fact that market interest rates have moved up is a lot more important and that means the cyclical recovery that we are seeing right now at some point in time will start to get deflated.

Bond fund managers are saying that the long and the short end of the curve indicate the bond market are pricing in not one, but three rate hikes?


In this case, is Reserve Bank of India really way behind the curve because the US bond rates are at 1.75% and the 10-year paper in America has already moved to 2.85-2.9%. Do you think in this case we should not get fixated by the future course of Reserve Bank of India rate action?

The fact is it is obviously about domestic inflation but there are so many other factors that are also driving the bond market, whether it is the global oil prices, it is the US long term interest rates or the fact that participation from local public sector banks has been a lot more muted and so the increase in the risk free rate for instance which is sort of the benchmark from which the pricing happens on most other instruments has to be seen in the context of not just whether the central bank is ahead or behind the curve but also the other dynamics that have changed.

What does it mean for different segments of the economy that are dependent on the pricing of loans like housing finance and auto business. How does this really flow through in terms of nurturing productivity gains that we have been seeing so far? Like you said, this is really about the RBIs endorsement that growth is coming back and we are encouraged by the data. But how sustainable are those numbers?

What the Reserve Bank does is very important from a signalling perspective but the bank response obviously is also a function of their own liquidity dynamics. Given the incremental credit deposit ratio and the gap we are seeing in the banking system. liquidity has tightened and therefore irrespective of the RBI action, banks raised their deposit rates and therefore in effect their lending rates have gone up.

The outlook for the broader segments that borrow is going to be a function of liquidity dynamics of the banking system and the RBI action. At this stage, both point to the same direction which is that incrementally there will be some increase in interest rates from the borrowers perspective.

What is quite intriguing is that within six months of an economic recovery, we have seen a significant build up in inflation pressure in India at a time when the balance sheet is clearly quite stressed.

We think it is sort of a signal that perhaps the potential capacity of this economy has come off and which is why we are seeing inflation pick up so quickly in the economic recovery cycle. If the central bank has a mandate of 4% inflation and the capacity of the economy is not to grow beyond a certain level, then the only way to bring inflation back to the target would be to ensure that growth stays close to potential rather than above potential.

The objective of monetary policy tightening now at this stage is to fizzle out some of the cyclical recovery. In the very near term, let us not forget that monetary policy works with huge lag. So, in the very near term, the growth numbers will continue to be very strong and we do think that in the June quarter, we will see a repeat of the growth number in the 7.5-8% range.

But given that financial conditions are tightening and higher oil prices is a negative, it means we will see some slowdown on economic activity in the second half of FY19.

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