Are we close to end of rate tightening?

Despite a quarter percentage point rate hike—the 10th hike in past 16 months—and a reasonably hawkish mid-quarterly monetary policy review statement from the Indian central bank, bond yields dropped last week and prices rose.

The yield on the benchmark 10-year, 7.8% government paper maturing in 2021, ended 11 basis points (bps) lower at 8.29% on Thursday, down from 8.4% the previous day. The drop in the five-year benchmark swap rate was even more spectacular—it ended 21 bps down; at 7.68% against 7.89% a day ago. The next day, the 10-year yield dropped further to 8.26% and five-year swap to 7.66%. One basis point is one-hundredth of
a percentage point.


This is an interesting development. While economists and analysts of brokerages are expecting another 25-75 bps rate hike in the rest of the year in sync with the Reserve Bank of India’s (RBI) strong anti-inflationary stance as inflation is unlikely to come down anytime soon, the market is clearly sensing that RBI is coming close to the end of its rate tightening cycle.
Indeed, the market’s view is short term as bond dealers focus on trading but more than domestic developments, the global scenario will play a critical role in influencing the Indian banking regulator’s monetary stance. While the policy continues to focus on containing inflation and anchoring inflationary expectations, there is a subtle change in the language, as has been pointed out by Manas Chakravarty in his Mark to Market column in this paper last week. The objective of the annual policy, announced in May, was to “sustain the growth in the medium term by containing inflation”; its June review spoke about mitigating “the risk to growth from potentially averse global developments”. Clearly, RBI is aware of the risk to growth and may shed its aggression on rate tightening going forward.
Does this mean that we have reached the end of the rate tightening cycle? Or, will RBI press the pause button after one more rate hike in July when it announces its quarterly monetary review? One cannot say this with certainty at this point, even as Europe struggles to contain the Greece sovereign debt crisis and US economic data continues to be disappointing. If, indeed, there is a dramatic deterioration in the global scenario, this can happen as Indian exports will suffer and that will impact growth.
For the July policy review, the most critical input will be corporate performance in the first quarter of the current fiscal, apart from the inflation trajectory and the progress of the monsoon. Corporate earnings growth and profit margins in the fourth quarter of fiscal 2011 were in line with the performance of first three quarters of last fiscal and, by RBI’s estimate, there is no impact on demand as yet and despite sharp increases in input costs, pricing power of companies has not yet been dented. Industrial lobby groups are, however, contesting this theory and according to many, RBI is consciously downplaying the risk to growth as it does not want to give up its fight against inflation even if that means choking growth.
If corporate earnings in the July quarter continue to be robust, pricing power of companies remains intact and inflation continues to rule high, one can expect the 11th rate hike in July. Wholesale price inflation rose to 9.06% in May and the non-food manufacturing inflation, a proxy for so-called core inflation, rose a full percentage point to 7.3%. What is more worrisome was the upward revision of the provisional core inflation number in March to 8.5%. As long as core inflation remains at this level, RBI will not reverse its policy stance. Only when core inflation comes down to 4.5%-5% and stays there for a few months, one can expect the Indian central bank to start paring its policy rate.
Will that happen by the end of this year? It all depends on the global developments. But one can safely presume that as things stand now, the policy rate may reach its peak at 7.75% or at 8%, and is unlikely to rise beyond that.
No-frills inclusion
The Skoch Development Foundation’s latest survey on the spread of banking services in India throws up some interesting facts. The total number of no-frills accounts as of 31 March stood at 74.3 million, but the number of active accounts reported by various banks varies between 3% and 20%. Although there is not much difference between growth rates, the number of urban households covered by no-frills accounts is nearly double that of rural households.
It also points out that out of 5,165 new branches opened in 2011, 21.86% are rural branches, much lower than what RBI norms stipulate. Going by the Indian banking regulator’s norms, one in every four branches, or 25%, should be located in rural pockets, but banks have not followed the policy. From now on, they will have no choice but to follow this as the central bank has made it clear that one-quarter of their new branches will have to be in rural India.
At this point, banks are depending mostly on business correspondents to reach out to rural folks. Only 3,500 villages have brick-and-mortar bank branches and about 500,000 habitations are left uncovered.
The Skoch survey also says the growth rate of self-help groups is declining; ditto about loans issued by cooperative banks; and growth in agriculture credit fell to 10.6% in 2010-11 from 22.9% the previous year. All in all, this is not a very happy situation when the government and the Indian banking regulator are in overdrive to spread the banking service as a critical tool for inclusive growth in the world’s second fastest growing major economy.