Indian rupee: RBI on hold but jittery over fiscal slippage

The Reserve Bank of India (RBI) left rates unchanged at 6% as expected and maintained a neutral bias. For fiscal year 2018-2019 it highlighted upside risks to inflation from fiscal slippage following the latest Union Budget which projects a fiscal deficit of 3.3% of GDP. However, it expects growth to bounce back above 7% and inflation to hold steady at 5%. RBI remains watchfully on hold for now as it sees the risks to growth and inflation as evenly balanced.

RBI left rates unchanged at 6% and stuck to its official neutral stance, saying this is consistent with its objective of price stability, defined as 4% inflation within the 2% to 6% band in the medium term. Its last policy change was a 25 basis points cut in August 2017 after inflation slipped to a nadir of just 1.5% year-on-year in June 2017 and growth suffered in the first half of 2017 due to the dual shocks of demonetisation and the nationwide introduction of the goods and services tax (GST). We see RBI as watchfully on hold for now as it sees the risks to inflation and growth as evenly balanced.

At the margin, the bias is tilted to the hawkish side given the swift rise in inflation in the past six months to above 5% in December 2017. This is above the mid-point of 4% and at the upper end of RBI’s inflation target range of 2% to 6%. RBI is projecting the possibility of inflation rising to 5.6% year-on-year in the first half of fiscal year 2018–2019 (i.e. between April and September 2018). However, it does not expect inflation to breach 6% and instead expects it to moderate in the second half of the fiscal year to average between 4.6% and 5% (Chart 1).

Chart 1: RBI expects CPI to stay below 6% despite fiscal slippage

Monthly RBI benchmark policy rate (reporate), CPI inflation rate

Chart 1: RBI expects CPI to stay below 6% despite fiscal slippage
Source: Central Statistics Office, Reserve Bank of India, Commerzbank Research

The vote split from the six-member panel was five to one for no change. We note that the one dissenter, Dr Patra, voted for a 25 basis points hike instead of no change last time. In the December meeting, the one dissenting vote was by Dr Dholakia who voted for a 25 basis points rate cut but voted for no change this time.  

The three key risks to inflation are likely to come from
1) a further rise in oil prices;
2) industrial non-oil raw material costs due to the ongoing recovery in the global economy;
3) the upcoming monsoon. This is always a key swing factor given India’s high dependence on rainfall for the agricultural sector and, in turn, food prices. This year’s monsoon is projected to be normal;
4) proposed hikes in customs duty on a number of items from the Union Budget; and
5) fiscal slippage from the Union Budget – the government is projecting a higher than expected fiscal deficit for the current fiscal year 2017–2018 at 3.5% of GDP versus 3.2% earlier. For fiscal year 2018–2019, it is projecting 3.3% of GDP versus the earlier projection of 3% which is the long-term fiscal consolidation target (Chart 2).

Chart 2: Fiscal consolidation still broadly intact

Union fiscal deficit of GDP (NEER)

Chart 2: Fiscal consolidation still broadly intact
Source: Bloomberg, Commerzbank Research

The two main mitigating factors that could keep a lid on inflation are first, a relatively subdued manufacturing capacity utilisation rate of around 72% in the third quarter of 2017; and second, a moderate rural real wage growth. Further, the implementation of the government’s House Rent Allowance (HRA) for government employees under the 7th Central Pay Commission (CPC) pushed up housing inflation in recent months. However, this is expected to dissipate in coming months barring no adverse impact from the staggered implementation from the various state governments.

On the growth outlook, RBI is relatively confident of a continued rebound after the dual shocks of last year. It is forecasting 6.6% the current fiscal year 2017-2018 and firmer at 7.2% for the upcoming one, measured on a gross value-added (GVA) basis. There are a number of positive drivers, including:
1) early indications of an improvement in investment spending;
2) improving global demand which should aid exports;
3) stabilisation in the GST implementation which should provide greater clarity for businesses; and
4) introduction of the recapitalisation plan for public sector banks. Large distressed assets are targeted for resolution under the Insolvency and Bankruptcy Code (IBC). The hope is that as public sector banks are recapitalised, it could encourage stronger lending in the economy. Furthermore, the focus in the Union Budget on the rural and infrastructure sectors could also help to shore up domestic demand.

Overall, we concur with RBI’s assessment that the risks to the economy and inflation are evenly balanced. We expect RBI to leave rates unchanged at 6% for the rest of this year. In terms of implications for the Indian rupee: the US dollar/Indian rupee exchange rate has in fact been rather stable, between 63.00 and 64.50 since the start of the year despite the US dollar’s weakness. Year-to-date, the rupee is down around 0.7% versus the US dollar as opposed to the average gain for Asian currencies of +0.6%, ranging from the likes of –2.8% (Philippine peso) to +3.2% (Chinese yuan). We suspect RBI will be quite happy to see the rupee underperform its peers and maintain a relatively stable dollar/rupee rate. There are no major reasons to engineer a much stronger or weaker Indian rupee for now. We are projecting a higher US dollar/rupee exchange rate at 65.50 by year end (Chart 3).

Chart 3: Indian rupee weaker on NEER basis in past year

Indian rupee versus US dollarˆ; and Indian rupee nominal eff‰ective exchange rate

Chart 3: Indian rupee weaker on NEER basis in past year
Source: Ministry of Finance, Commerzbank Research