Given that monetary policy typically impacts the economy with lags, waiting for demand-led inflation to gather steam before altering the liquidity strategy may lead to worries about whether the central bank will find itself behind the curve going forward, Varma said. Edited excerpts:
Let’s start with your reading of what the RBI Governor said in the last policy. There was an unequivocal emphasis on growth but some signs such as a dissent on the stance and action on the liquidity front suggest the statement was not ‘as dovish as before’.
Compared to the last policy I thought it was perhaps hawkish at the margin.
In terms of the communication from the RBI, it is steady as there is no change in anything despite the changes in the macro projections. They have reiterated the accommodative stance, the priority on growth and support to the economy till growth revives and sustains. But, reading between the lines, the reason I say hawkish slightly at the margin is because it was not a unanimous decision anymore.
I suspect even for those who did not dissent, there are concerns around continuing to signal accommodation with a specific wording on how long the MPC is going to be accommodative.
Secondly, there was the VRRR. The governor did go out of his way to say that this should not be seen as normalisation. But in our view it is a small step towards calibrated liquidity normalisation.
Typically, when we think of monetary policy normalisation, the reversal starts with liquidity before it actually moves to the interest rate side (repo rates). Within liquidity, the RBI will typically start with temporary liquidity measures (such as VRRR) before they move to permanent liquidity measures (less or no GSAP).
Perhaps what was most widely discussed in markets after the last policy was liquidity. The liquidity surplus in the banking system is currently near record highs. Does this pose challenges for a central bank which is potentially looking at a tricky growth-inflation mix?
The fundamental question here is how long we should be comfortable letting liquidity stay as ample as it is? The current judgement seems to be that given inflation is largely supply side driven and credit off-take has not really picked up, so even though liquidity is ample, the risk of inflation becoming demand-led and expectations becoming entrenched is quite low.
Therefore a more benign view has been taken around liquidity.
Our own judgement is that the economy does not need this quantum of liquidity and allowing ample liquidity conditions to continue for too long will create macro challenges down the line.
In terms of growth — we think there has been a fairly swift cyclical recovery.
On inflation, our view is this is not transitory, for various reasons.
We know that monetary policy tends to have lagged effects, so waiting for demand-side inflation to pick up before changing the liquidity strategy will be too late. The worry is whether the RBI is going to be behind the curve as we move forward. We think that the calibrated normalisation on liquidity should continue. Monetary policy has to be forward looking in its approach.
What is your reading on the growth front? The jury is out on a potential third wave and so far, high-frequency indicators suggest July-September has seen much improvement.
Our growth projections are above the RBI’s projections, we are at 10.4% for FY22.
The third wave is a risk and that is something we are monitoring. It is hard to predict a third wave.
We believe that India is in the initial stages of a business cycle recovery.
The moderation in India’s growth cycle really started in late-2018 because of the shadow banking crisis and then the global slowdown. We were still at the lows of that down-cycle when the COVID shock hit.
What we have seen after the first wave and then the second wave is that we are normalising back to pre-pandemic levels. At Nomura, we have been tracking a weekly business resumption index. In mid-August, the Nomura India Business Resumption Index crossed the pre-pandemic level of 100 for the first time since this series was initiated in early 2020.
This is obviously an aggregate and there is unevenness within different sectors but we are inching towards pre-pandemic levels.
We still do think that the business cycle is headed higher and that is primarily because financial conditions in India are extremely accommodative, both in terms of liquidity and the cost of capital.
The uncertainty around the pandemic has led consumers and businesses to defer their decisions. So while financial conditions have been extremely accommodative, they have not necessarily triggered the kind of growth impulse that you would have typically expected.
As we go forward; if indeed India manages to vaccinate a greater part of the adult population by the end of this year, then uncertainty should come down and that in turn implies that the decisions that have been postponed will essentially get back to the drawing board.
Our view is that given the RBI remains extremely growth focussed, some of the more discretionary segments are likely to see a bigger growth impulse. These would include consumer discretionary side or the housing market,
The export cycle, of course, as of now is doing well and that typically tends to be supportive a bit at the margin on the investment side as well. Plus the government is very clear that they are not going to compromise on capital expenditure. When we put all of this together, we have very accommodative financial conditions, vaccinations that are going to progress, uncertainty which should be coming down and steady global growth. All these factors should be growth supportive.
How much comfort would the July CPI print (which was at a 3-month low) provide to the RBI?
The latest CPI is back to the 2% to 6% range which is good. But is average inflation of 5.7% for the financial year okay, given where the output gap is? We think inflation risks are high for various reasons.
First, the sequential contraction in GDP growth in Q1 FY22 is likely to be much lesser than what is currently estimated by the RBI in our view. In the July-September quarter, it looks like there is a strong recovery.
The demand side factors are actually coming through; a lot of the inflation has been driven more by the goods side of the economy. Going forward, the services side is going to see more inflation as activity continues to pick up.
Second, the other pandemic effect has been more consolidation with the bigger entities becoming even bigger and that will cause greater market consolidation. This typically leads to greater pricing power from the dominant players.
The third trend we are seeing is companies like those in the telecom sector which just have to clean up the balance sheet and therefore are increasing prices.
Fourth, the RBI’s own survey of inflation expectations, the latest reading, is consistent with underlying inflation of at least 5.5%.
When we put it all together, it is clear that inflation is supply side, but is it really transitory?
The risk is that either the supply side issues will continue if there is a third wave (hopefully not) or if there is continued demand recovery. Then inflation will shift from being a supply side to a demand side issue. As I said earlier, monetary policy works with long lags and the RBI is not even signalling any reversal right now.
The risk is that expectations actually become more entrenched. At the margin, the weightage assigned to inflation needs to increase (relative to growth) and at the minimum what monetary policy should do is normalise on liquidity.
Much has been spoken about India’s potential growth and how long it will take for a sustained recovery. Public debt has been rising for some time now. Could we, at some point when the dust has settled on the pandemic, be faced with an issue of the debt-to-GDP ratio and rating downgrades?
There are two separate issues; one is whether debt is unsustainable and two how rating agencies are going to look at India. On the first question, our debt is sustainable. A simple metric to assess this is r-g, or the interest rate-growth differentials. Nominal GDP growth in India is much higher than the weighted average cost of our outstanding debt.
Rating agencies also do not see India’s debt as unsustainable, but the question is how fast the public debt-to-GDP ratio will fall. This is very sensitive to assumptions on fast nominal GDP growth.
For rating agencies, the fundamental concerns are India’s relatively weak fiscal parameters and the medium term growth outlook. India does have higher real GDP growth relative to peers but the fiscal side parameters both in terms of the deficit as well as the debt to GDP ratio are significantly higher.
Will the reforms that the government is implementing right now, the capex push from the government – all of this reverse the decline in investment to GDP and push the capex cycle higher? We don’t know.
If that happens, then that will of course support much higher revenue growth and that will be positive in turn for tax revenues which will help to bring down the fiscal deficit as well as debt to GDP ratio over time.
The answer to this question will only be known over a period of time.
We spoke about how the government’s revenues have shown improvement in the current financial year. Do you see the fiscal deficit target being met?
Most numbers as of now suggest that 6.8% will be met.
On the revenue side, there has been a higher than budgeted dividend from the RBI and we expect the tax collections to be much higher.
As I said, on the growth front, we are more optimistic and with inflation high, the normal GDP driven tax buoyancy is actually going to be in favour of the government. We are seeing that with the higher indirect tax collections. There is still some risk on the disinvestment side but when we put the entire revenue picture together, it does look like the government will easily meet its revenue targets.
