“The headroom for further monetary easing remains quite limited” was enough for the Sensex and Nifty to fall by over 1.5% and for the 8.15% 2022 government bond yield to rise by 6bps. The markets are reading the RBI statement as no rate cuts going forward unless there is a fall in food inflation that is trending at 11.4% levels. RBI is spooking the markets with its focus on food inflation at a time when non food manufacturing inflation is trending at multi year lows of 3.8% levels while GDP growth for fiscal 2012-13 is expected at decade lows of 5%.
RBI feels it has done enough for the present to address growth issues. The central bank has cut repo rates by 100bps and CRR by 75bps in fiscal 2012-13 and it has bought government bonds of around Rs 160,000 crores (equivalent to 250bps of CRR cuts). RBI is now indicating that it will wait and watch for further signs of growth slowdown to take action on policy rates.
RBI guiding for no rate cuts in its 3rd May 2013-14 annual policy is not positive. Banks will have no inclination to lower lending rates at a time when there is continuous stress on assets due to a weakening economy. Banks will not strive for credit growth given that reduction in Non Performing Assets (NPAs) will be the priority. Banks will buy government bonds, as it will be seen as a safe asset in times of stressed balance sheets. Banks NPAs have risen by 50% in the first none months of this fiscal reflecting the stress on balance sheets due to economic slowdown.
The government benefits from banks buying government bonds as it can push through borrowing of Rs 579,000 crores in fiscal 2013-14. However banks buying government bonds will not help the economy in any way unless government bond yields trend down to levels where banks find it more worthwhile to lend to the economy. In short banks have to be discouraged from buying government bonds and that will not happen unless government bond yields fall, economic growth improves and banks become more comfortable on credit.
RBIs hawkish tone on further rate cuts suggest that government bond yields will not fall as markets will be reluctant to fund the government at lower levels of yields. Economic growth will not happen as lending rates stay high in the economy while banks will continue to shy away from credit exposures on NPA worries.
The question the RBI will now have to ask itself is “what purpose will a status quo on policy rates achieve?” If the answer is that it will contain inflation expectations leading to a fundamentally stronger economy that can in turn lead to sustainable economic growth, then it is best to keep rates on hold. On the other hand if no rate cuts lead to inflation expectations remaining high and economic growth falling off a cliff then rates should either be pushed up or lowered. Doing nothing does not help.
In the meanwhile markets will have created enough volatility to hurt sentiments on the economy. Until 3rd May 2013 Amen.