India: Time for a Meaningful Cut in Lending Rates?

The RBI’s right move on tightening monetary policy in late 2006

At a time when many other countries in the region are facing the tough task of managing inflation, India’s central bank has successfully managed to address this challenge. The RBI has effectively reduced the overheating in the economy by initiating aggressive monetary policy tightening and allowing sharp currency appreciation. Although many market participants criticized these two policy moves at the time, currently India appears to be well positioned to manage inflation risks. Indeed, the RBI had started discouraging mortgage loans by tightening credit norms well before the subprime crisis started in the US.

Growth slowing significantly, need to cut lending rates

The monetary policy tightening has indeed reduced the overheating and financial instability risks. The key question now facing the central bank is whether it should cut the policy rates to ensure banks’ lending rates are reduced significantly, which is warranted by the slowing growth trend. We believe that the relatively high level of lending rates has already resulted in a sharp reduction in consumption growth. This is evident in the consumer goods production growth, which has decelerated sharply to 3.2% during the three months ended November 2007 from the peak of 18.5% in June 2005.

The leveraged spending by households has already declined sharply, as reflected in two-wheeler sales, consumer durables production and mortgage lending growth.

In addition to the sharp deceleration in consumption growth, the export sector has also suffered a slowdown because of weakening demand in the developed world and appreciation in the rupee. Export growth in rupee terms has weakened to an average of 6.9% over the past six months, compared with 23.3% during the 12 months ended March 2007. With the US economy likely to face recession in the first two quarters of 2008, a further slowdown in exports is inevitable, in our view.

Hence, two out of the three engines of growth (consumption, exports and capex) are already faltering.

Private corporate capex remains the bright spot. Although some amount of slowdown in consumption was critical to reduce the overheating risk, the extended duration of this weaker growth phase could cause serious damage to the overall growth momentum. We believe that the risk is that this sharp slowdown in demand for final goods could start to weigh on the corporate sector’s confidence for investment.

The aggressive pick-up in corporate investment two years ago is now beginning to bear fruit in the form of operative capacity available for production. In our view, weaker sales growth when the capital charge for new capacity is increasing will hurt corporate profitability and sentiment. We believe that lending rates need to decline by about 150bp soon to ensure that credit growth does not dip decisively below 20%.

Challenges to cutting rates

The RBI, however, has been conveying its challenges in cutting policy rates. The most important challenge it is facing is managing headline inflation below its comfort zone of 5%. Although headline inflation declined to 3% during the week ended November 24, 2007, it accelerated back to 3.8% during the week ended January 5, 2008.

First, the headline inflation is hugely understated for oil prices. According to Morgan Stanley oil and gas analyst Vinay Jaising, the current weighted average realization of oil products in the domestic market implies an average crude oil price of US$63/bbl (WTI), versus the current international market price of US$90/bbl. Even assuming that crude oil prices of US$90/bbl are unsustainable and the government needs to mark the domestic prices to US$75/bbl, headline inflation would rise to 4.5% from the current 3.8% before considering the cascading impact of this on other products.

Second, the RBI is concerned about food prices. With international food prices reaccelerating recently and the possibility of a potentially weak crop output during the winter season (harvesting for which is due in February-March), the risk of food inflation rising from the recent lows of 2.3% during the week ended November 10, 2007 is increasing.

The third and most important issue worrying the central bank is potential continued risk aversion in the global financial markets, which in turn could result in capital outflows (see Subprime, Risk Aversion and India, August 16, 2007). Note that unlike many other emerging markets, India runs a current account deficit. If capital outflows accelerate, the rupee would depreciate, resulting in added concerns for inflation. The rupee has been trading in an over-valued range for a while, only with the support of large capital inflows.

Political system’s tolerance for inflation is low

We believe that the Indian political system has lower tolerance for even supply-side inflationary pressures from oil and food, even if the second-round effects are manageable. Although general elections are held after a gap of five years, the frequent state elections result in great concern for headline inflation among the politicians. Although strong GDP growth benefits higher income groups more than lower income groups, the rise in inflation hurts the poor more than the rich.

With the proportion of poor outnumbering the proportion of rich in the population, policy-makers would prefer to err on the side of caution to ensure that inflation remains low.

Moreover, in India the politicians focus on headline inflation rather than core inflation. This is because the consumer cares little whether the source of inflation is demand-side or supply-side pressure and whether it is due to local or global factors. In other words, the politicians would like to keep demand-side inflation even lower if the risks of a supply shock are high. This discussion assumes greater importance as general elections are likely to be held in the next 12-15 months. With headline inflation having already spiked above the comfort zone of 5% before retracing to the current 3.8%, the government appears to be determined not to allow it to rise above this level again before the general election.

Risk of reverting to lower equilibrium growth rates

The cost of interest rates staying higher for longer would be significant if it results in a slowdown in the capex cycle, as weak consumption would damage confidence in the corporate sector. In many ways, the root of this problem lies in India’s weak political system, which prevents the country from transitioning to higher equilibrium growth rates. A large pool of capital inflows into the country since the second half of 2003 provided a great opportunity for the country to move to 9%-plus growth on a sustainable basis, from 6-6.5% growth levels prior to this period. However, the weak supply-side response (capacity creation) from the government restrains the pace at which India can lift its sustainable growth rate.

Although large inflows pushed real interest rates lower, a weaker response from the government to accelerate infrastructure investment resulted in this liquidity getting absorbed for consumption and fueling asset prices (particularly property). At the start of the current growth cycle in 2004, the GDP growth trend was below potential (GDP for the five years ending F2003 rose just 5.3% compared with the potential growth of 6.5% at the time). This meant that strong consumption growth in the initial phase did not cause any overheating. However, we believe that, by early 2006, the economy was overheating as capacity growth remained slow. Moreover, even as private capex has picked up significantly to an estimated 13.7% in F2007 from 5.9% in F2003, infrastructure capex has improved at a relatively slower pace, to 4.2% in F2007 from 3.5% in F2003. We believe that infrastructure spending should be 7-8% of GDP to sustain 9%-plus GDP growth. This slow pace of infrastructure investment growth restrains the overall ‘effective’ capacity growth. The overheating in the economy caused by stronger growth in demand relative to effective capacity growth forces early monetary policy tightening. This in turns brings down demand growth.

In others words, this slow response from the government keeps sustainable equilibrium growth below the underlying potential of the economy. We believe that the current effective capacity growth can sustain 7-7.5% growth without overheating.

Outcome of this cycle to depend on global factors

The outcome of the current cycle will depend on the trend in global commodity prices and global risk appetite. India needs a fall in commodity prices to reduce the inflation pressure. The decline in commodity prices could reduce the supply shock concerns, allowing the RBI to cut policy rates and thus reviving domestic private consumption. However, at the same time, India needs the global risk appetite trend to be constructive so that the capital inflow trend does not reverse. This would ensure that the government gets more time to respond on accelerating infrastructure investment and overall effective capacity growth. If the recent global market turmoil lasts longer, it will affect the trend of capital inflows into India and therefore the near-term growth trend, in our view.

By Chetan Ahya Singapore
Morgan Stanley
January 23, 2008