(Nipun Mehta is a veteran private banker with many years of experience across Asia. The views expressed in the column are his own and not those of Reuters)
The Reserve Bank of India on Tuesday quite unexpectedly raised interest rates by as much as 50 basis points. It was a move that shocked the street and took a lot of people by surprise. It was also a move showing aggressive intent at inflation management.
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How is this announcement being viewed by the street? What are the implications of such a hike when interest rates were expected to have almost peaked?
It’s an accepted fact now that various efforts at inflation management have either been unjustifiably inadequate or completely missing. It’s also an accepted fact that much more than this being a demand-led inflation, this is a lack-of-adequate-supply led inflation or what is better known as inadequate supply chain management. Hence raising interest rates at this pace (11 times in the last 17 months) cannot achieve the kind of impact that improvement in supply through preventing hoarding or improving farm produce can.
To play good music one needs an orchestra with several musicians playing various instruments simultaneously. On the other hand what we have is the RBI alone trying to play its instrument and others (read the government) just watching in the hope that the lone musician will create the effect of an orchestra, and bring inflation under control. Merely raising interest rates will not bring down inflation fast enough.
With limited hope of inflation coming under control in the next quarter or two, one should expect more rate hikes in the coming months.
A couple of observations made by the RBI governor warrant a mention. His concern that meeting the fiscal deficit target could be a challenge, and the fact that economic growth had moderated but there is no economic slowdown. The latter observation is important as it is contrary to the observation made by several Bank heads as well as industry chiefs. If there isn’t an economic slowdown, this, and the subsequent interest rate hikes will ensure that. Importantly, the subsidy burden, the excise duty cuts, etc will ensure a higher fiscal deficit, and that can be inflationary too.
What this rate hike will achieve is to slow down consumer spending and the clamour for housing and vehicle loans. Will it also slow down investment spending by the corporate sector? Well, large corporates will always have the luxury of continuing their investment spends by borrowing at lower rates from global markets. It is the small and mid-sized companies that will feel the pinch and postpone capex. Even working capital loans at the enhanced cost will further hurt these small and mid-sized companies whose margins have been under pressure in light of increasing competition or higher input costs.
For the street, this was an unexpected development and it reacted accordingly. With global economic uncertainties in the U.S. and the EU, a constant threat of sharp rating downgrades for several countries, the persistent fear of potential payment default by any one country resulting in a cascading effect, investors will be wary. While earning downgrades have often been spoken about, we haven’t seen any drastic downgrade reports or even a downward re-rating of a sector (except maybe the real estate sector, that too more for reasons of governance, or the lack of it). Isn’t this rate hike enough reason?
With economic uncertainties globally as well as nearer home in abundance, Indian equity markets will continue to remain in a range bound mode for a while longer. Inflation, which has been the bugbear for the Indian economy for almost 2 years now, will be very closely watched as the size and frequency of subsequent rate hikes could create seriously negative sentiment all round.
