RBI's Monetary Policy Review: A De Facto Hawkish Tilt Belies Market Expectations

The monetary policy announcement holding the policy rates unchanged largely encircled the official narrative of a feel-exuberant growth, projected at 7% in FY25 and 7.3% in FY24, navigated through the adroit fiscal and monetary policy management from the peak inflation levels in FY23.

While the misplaced narrative of a decoupled Indian economy from the slowing global growth is a reiteration of RBI’s earlier statements, what is noticeable is the emphasis on mostly supply-side-driven factors, rather than demand-driven ones.

“India’s potential growth is propelled by structural drivers like improving physical infrastructure; development of world class digital and payments technology; ease of doing business; enhanced labor force participation; and improved quality of fiscal spending,” the RBI governor said.

However, weak real consumption demand, as reflected in corporate sales, declining core inflation, and expenditure GDP data, indicates that the growth problem is on the demand side, not on the supply side.

While the MPC statement points to the decline in core inflation, excluding food and fuel, to sub-4%, the central bank acknowledges the rising importance of persistently high food inflation in driving the headline inflation and the need to sustain a restrictive monetary stance. The headline inflation has ranged from 4.3% to 7.4% during FY24 (till Dec 2023) and averaged 6% on a four-year CAGR.

This change in position on food inflation—historically seen as seasonal and transient—is backed by recent RBI research (following our theme that India’s high food inflation has deeper roots than meets the eye) which shows demand elements are also behind high food inflation.

Thus, while the RBI’s growth assessment points towards supply-side strengths behind India’s rising potential growth, the fact that inflation at 5.7% is way higher than RBI’s target of 4%, along with the risk of it getting de-anchored despite very weak demand conditions, hints at the emptiness of such claims.

This fallacy is also exemplified by the fact that while the real output GDP (GVA) or the supply side is estimated to have grown at 7.6% in H1 FY24, the real expenditure GDP (ex-discrepancies) and real personal expenditure, representing the demand side, have grown much less at 2.3% and 4.5%, respectively. Ideally, a situation of supply growth outstripping demand should have led to deflation and a current account surplus. As this is not the current situation, the de facto potential growth is probably lower than the demand growth.

Also, the RBI’s claims of a decoupled Indian economy from global slowdown are probably backed by a low correlation of the headline real GDP growth with that of the US, Europe, and China (Mar 2021- September 2023). But the sensitivity rises significantly once we consider India’s real GDP excluding the discrepancy component. This means that the proposition of a decoupled Indian economy is misleading.

The lagging de facto potential growth is also having a significant bearing on the banking system.

Representing the historical peaks, the credit-deposit ratio of banks has risen to 80% (January 2024, 10 percentage points in 2 years, ex HDFC merger) and total allocation (bank credit, SLR investments, and cash balance) to deposit ratio has also risen to 115%. The last peak of 114% in total allocation was seen in June 2008--just before the global financial crisis. Such peaks typically mark the onset of declining financial savings of households, impacting deposit growth and lending growth outstripping the ability of banks to fund future growth. The subsequent onset of the growth slowdown marks the decline in lending growth and the onset of the NPA cycle.

Importantly, the 2008 peak was preceded by a long phase of a robust mix of strong private capex and retail lending growth, predominantly mortgage loans. Contrastingly, the current peak of bank allocation/deposit is much weaker, fueled largely by exuberant uncollateralised retail lending growing at 25-30% to fund household consumption amid declining real disposable incomes, and negligible private capex funding.

Hence, the imminent problem the RBI now faces is to curb retail lending growth even before the revival of the long anaemic private capex cycle. The policy rate hikes from the Covid low of 3.35% to the current 6.5% and the liquidity tightening have failed to temper retail lending as the RBI sustained the post-pandemic regulatory forbearance far too long to revive consumption demand.

Thus, as a lagged reaction, the RBI has recently acted decisively to contain uncollateralised retail lending through increases in risk weights and annulling the scope of banks to evergreen NPAs using the AIF route. It is also trying to convince banks to reduce their credit-deposit ratios.

However, these attempts are still on the milder side as the pass-through of the cumulative monetary tightening till now has been partial (May 2022–December 2023). The weighted average lending rate on fresh rupee loans and outstanding loans has risen by just 181 basis points and 113 basis points, respectively, much less than hikes in deposit rates. The average domestic term deposit rates on fresh and outstanding deposits has risen by 246 bps and 180 bps, respectively.

Hence, both the RBI and the central government are trying to drag the demand side further to align with the de facto lower potential growth by a) intensifying the tightening measures to bring down the credit-deposit ratio of banks; and b) reducing fiscal support by a larger reduction in the fiscal deficit (5.1% in FY25E and further to 4.5%). The post-GFC 2008 history suggests that the equilibrium for the banking sector is reached when the overall allocation-deposit ratio falls to 109-110%, which from the current 115% would mean a considerable slowdown in credit growth and a significant rise in retail NPAs.

Hence, with the RBI now envisaging full transmission of past rate hikes and simultaneously taming inflation close to 4%, which is still not the base case projection of the central bank in FY25, retail lending rates will need to edge higher, not lower. This is contrary to the consensus view favoring early and deep rate cuts by the RBI. On the contrary, the RBI’s stance appears to be adopting a tight regime, longer than what markets were expecting. The adjustment phase can turn shorter if there is a recession leading to a steep decline in global commodity prices (like in 2014). Conversely, it can get more challenging if due to the extant geopolitical conflicts, crude prices flare up further (as in 2008).

From the market standpoint, the RBI’s first policy in 2024 is de facto hawkish and waters down the rising expectations of early and deep rate cuts. This was reflected in the sharp correction in Bank Nifty and its constituents and other rate-sensitive sectors such as real estate. We have been underweighting the BFSI sector for a little over two years and it is borne out by the fact that the contribution of the banking sector in overall market capitalisation has declined to a multi-year low. Consumption sectors backed by leveraged spending, especially automobiles, have outperformed significantly. But as the credit tightening pans out, the impetus on leverage consumption may also mellow.

Dhananjay Sinha is co-head of equities and head of research, strategy and economics, Systematix Group.

The views expressed here are those of the author and do not necessarily represent the views of BQ Prime or its editorial team.