Will RBI go for rate cut despite high inflation and CAD?

Reserve Bank of India is most likely to cut repo rate by 25 bps in its monetary policy review scheduled on March 19. Around 90 percent of participant in CNBC-TV18 poll of bankers and economist expect 25 bps rate cut and only 10 percent expect repo rate to remain unchanged.

However, Consumer Price Index (CPI) inflation continues to remain in double digit, which poses a question of whether the central bank should go for a rate cut in next policy or not. High current account deficit also points at an underlying demand in the economy.

Upbeat Jan IIP, dismal CPI: Where does this leave RBI?

Latha Venkatesh of CNBC-TV18 in discussion with Saumitra Chaudhuri of the planning commission, N Seshadri, from Bank of India and A Prasanna from ICICI Securities Primary Dealership unit focuses on what RBI ought to do in the upcoming monetart policy.

Below is the verbatim transcript of the discussion.

Q: In the first place, Consume Price Index (CPI) is still at 10.9 percent, a rather ugly number that affects more Indians. As well, current account deficit (CAD)December number when it comes, is likely to be 6 percent, some believe even over 6 percent. Is that comfort zone for a monetary authority to cut rates?

Chaudhuri: As far as CAD is concerned, the CAD is large not because there is a very strong demand, excess demand in the country but for some other reasons. I think the nexus between that and monetary policy isn't there in a very direct fashion. As far as CPI is concerned, CPI number is very high because, CPI has a much larger weight for food. As you may have noticed food grain prices particularly rice and wheat are high because of - reflecting past increases in MSP (Minimum Selling Price). So that's why CPI is much higher than the WPI (Wholesale Price Index). As far as direction of inflation is concerned, other than food, yes there is a downswing and that downswing reflects to some extent, stabilisation of inflation.

Q: The current account deficit being kind of immune to any demand from the citizen at large, how can we arrive at that conclusion? After all, we are seeing oil imports still high which means there is the ability to buy and therefore the current account deficit will not go down sizably anytime soon. Clearly, that is an underlying demand in the economy that is not being controlled by the right policies. We are going to face the current account deficit problem for several more months to come, won't we?

Chaudhuri: The main reason why the current account deficit was so large in the quarter ended December as you suggest, is because gold imports are much higher in that quarter. It's very high and it is also very high in January and February. I don't see how monetary policy can affect the demand for gold.

Q: It can, won't it? If the reduce the interest rates in the economy, there is perhaps that much more people you are pushing into gold since they perceive negative real interest rate.

Chaudhuri: I don't agree with that very much. I think people who buy gold are not the kind of people who line up to put money in fixed deposits. It is the kind of people who otherwise probably buy stocks or mutual funds or insurance products. It is really a problem if marketing of those products and their attractiveness that possibly has driven gold up, plus the fact that lately most of the gold imports or large parts of the gold imports is being done by banks that are running ETFs (Exchange Traded Funds).

So these are different kinds of demands. I don't think that they are very rate sensitive and we have to basically increase the appetite for financial paper which will take some time. That is probably the most proximate reason why the current account deficit will be high in the quarter ended December, other than the fact that also net individual earnings might be bit slower. Perhaps software earnings have been hit a bit. If you look at topline of listed software companies, the results are not very encouraging for the December ended quarter. Hopefully, they will be better in the current quarter, which may have also led to high current account deficit. So I think these are the separate set of issues all together.

Q: Non oil imports are falling. That is the only softer part which is keeping the current account deficit from looking even uglier. If the purpose of the rate cut actually is to increase industrial consumption and industrial output, then directly it will increase non oil imports, won't it? So, can you really buy the argument that cutting interest rates will not increase non oil imports?

Prasanna: What you have to realise is that there is always a lag. RBI has cut rates, banks are in the process of passing it on and obviously the economy has to respond. So probably you are going to have a lag of several quarters before a cut of 25-50 or more is going to percolate through the economy and therefore being felt in non oil imports. As far as oil import is concerned, it is falling because of repressed price signals. So as the government freeze up those prices, as you will see those imports coming down or actually the growth slowing down. So I think some balance can be struck and therefore I am not that worried about current account deficit going up because of RBI's actions.

Q: The CPI is at an elevated levels of 11 percent; can the monetary authority bring it down with an argument that it has no impact on food prices anyway? It has continued to be in double digits for past three years and it is definitely having a direct impact on the deposit rates. Savers are not willing to walk into banks at anything less than 9-9.25 percent for an annual deposit. Therefore, don't you think the Reserve Bank should worry about CPI and perhaps think twice about a rate cut?

Prasanna: I think there are two reasons to worry about it. One is even if you exclude food and fuel, the other part of CPI what you may call it, core CPI is also actually inching up and is also at an elevated level. I think it is around 8.5 percent. So that is not matter to be trifled with. The second issue I think is food inflation is largely structural in nature. It is driven by high MSP prices. I think government's procurement policies as well as some of the welfare programs are pushing wages at the rural part of the country. So these are factors which are not going away and therefore there is a large structural element to inflation in India and that is something which a monetary authority cannot ignore.

So I think what this tells you is that there is a limited room for RBI, irrespective of how non-food manufacturing inflation (which is anyway an artificial construct as far as I am concerned), crashes down, I don't think it opens up too much room for RBI to cut rates.

Q: If the Reserve Bank indeed were to give you a rate cut, will you really be able to reduce deposits or lending rates in the next couple of months?

Seshadri: I don't think we will be able to reduce the interest rate that we pay on deposits especially the retail deposits because there must be an incentive to save. Unless and until the headline inflation comes down in real sense, reduction in deposit rates will be counter productive and banks do need resources especially with the last quarter where there is a huge amount of churning of the liabilities. Banks would have to really continue and that is the reason why you find very high interest rates regime on the deposits. However, if you really compare the position that existed last year on a quarter on quarter basis, there is a reduction in the liability cost which is in tune with the direction in the inflation rates.

But there is absolutely not much of a room for the banks to reduce the deposit rates unless and until there is a real downward movement of inflation rates. The growth has been a concern for the banks and definitely interest rate cycle has been a key concern. In order to see that in fact there is a push up of the credit. Banks would be in a position to basically pass on any repo rate cut possibly on account of downward cost of funds in fact between the two periods. Any further reduction would be possible only when the liability cost comes down substantially.

Q: What you are saying is there maybe a small window to lower lending rates in the next two or three months if the repo rate were cut?

Seshadri: Yes. 25 bps is at best which can come but any further reduction is going to be independent reduction unless they curtail inflation in sync.

Q: Unless inflation moves down you will not be able to bring down deposit and lending rates, therefore any increase in loan off take also does not look possible for you. You are admitting that beyond quarter percent you will not be able to lower rates and therefore encouraging lending through lower rates does not look very likely in the foreseeable future?

Seshadri: Definitely lending in certain segments have happened by reducing the interest rates specially in the retail segment and some of the SME segment, but the scope for deep reduction in interest rate and a big jump in the credit off take can happen only when the inflation ease off.

Q: The other issue I wanted to discuss is the fiscal deficit and the hike in diesel prices. Do you think we are doing enough to control the diesel demand and thereby controlling current account deficit. Should we not at some point in time have to increase this dose by at least one substantial jump in diesel price?

Chaudhuri: These things are matter of managing the increase. It is not a very easy thing to do and one only wishes they had begun earlier on these small increases. Small increases are better than no increases. Small steady increases are even better than small unsteady increases. At least we are getting some increase and some adjustments. The fact is the consumer is better placed to adjust if the increases are small and regular rather than the increase is significantly large. One can argue this in any which way. One can take any position which is possible. They all will have some validity but this is one way the system is working and as long as it is moving in the right direction, I am okay with it.

Q: I was just wondering if the current account deficit will suddenly balloon so much because of oil imports contributing substantially and thereby foreseeing hand at a latter date?

Chaudhuri: Current account deficit has ballooned to some extent because of oil, but oil is not the surprise element. Surprise element has really been gold. We thought gold imports will come off and it has not come off anywhere near as much as we thought. That is a surprise element and we have all the banks setting up ETFs. They are the ones who are importing gold so unless the whole dynamic changes a bit against gold as an asset class we will continue to have some problems.