The 'third shock' and the RBI rate hike

After Covid and the Russia-Ukraine war, unprecedented monetary tightening by the US and the West has been described as the “third shock” by the Reserve Bank of India Governor Shaktikanta Das as he unveiled the latest monetary policy by hiking the guidance interest rate for the financial sector by 50 basis points on September 30.

The hike, fourth during the current financial year, totals up to 1.90 per cent and the repo rate (RBI’s overnight lending rate to banks) has in fact risen by almost 50 per cent from its base of 4per cent barely four months ago. Such spikes are rare though not unprecedented.

While it is known that the increase will lead to an across-the-board uptick in costs of borrowing for all classes of borrowers, this might also lead to a better return on deposits for those who keep money in banks. With retail inflation at 7per cent, there were comments that depositors were getting a net negative return as the interest rates on most banks’ deposits were lower than this. Now, there is an outside chance that for certain maturities, banks may offer higher rates, especially as deposit growth so far has been only 9-10per cent against a jump in credit deployment by about 16per cent. So banks will be looking to raise deposits in order to meet the increased credit demand.

However, what is strikingly different about the rate increase announced by RBI are the external factors which might have impinged on the decision making by the Monetary Policy Committee. It is to be noted that the RBI top brass was firm in its assertion that “domestic factors” dictated our monetary policy and the 50 basis point increase is to deal with the elevated levels of inflation.

There are at least three factors which are external but in any realistic analysis have to be accepted as having a domestic impact.

US Fed Funds Rate

First is the rate increase and the stance of the US Federal Reserve, the world’s most powerful monetary authority.

Last week, the US Federal Reserve not only increased the Fed Funds Rate by 75 basis points but stated that it is not fully done yet, indicating that further rate increases are on the way. The gap between US Dollar and Rupee interest rates had narrowed and the rupee depreciated suddenly crossing the psychologically important mark of 80. It is now trading at about 81-plus levels and all of the defence of the rupee even utilising our considerable forex reserves seems not to have helped.

The reserves themselves have seen a depletion from about $630 billion to about $540 billion partly because of the using up of a portion of the reserves to sell dollars in the market to prop up the rupee but in line with international trends where all major currencies have lost value agains the dollar —including the Pound Sterling, the Euro and the Yen — the Indian currency has also tumbled.

A depreciating rupee has both a cause & effect relationship with Foreign Portffolio flows. Whatever gains investors had made in the Indian stock market were being eaten away by a depreciating currency. And as they withdrew from the equity markets, it led to further demand for dollars in the market for repatriation of their investments even while fresh inflows dwindled.

Retail inflation

Second is the “imported” nature of our retail inflation. The increase in retail prices began with the spike in crude oil prices in the wake of the Russia-Ukraine war. Crude oil crossed even $125 per barrel though following the opening up of the supply lines somewhat and the fears of a global slowdown in demand, it has retraced to levels below $90. For an economy which is almost entirely import-dependent for its petrol and diesel requirements, the spillover of this spike was felt in the prices of goods across markets. Also relevant is the fact that commodity prices including those of cereals rose following supply disruptions. Rice and wheat prices in India too got a leg-up in a sympathetic response to this international trend though the Government quickly acted to put curbs on exports in order to protect the domestic consumers.

Tightening interest rates

Third but not definitely any less important is the tightening of interest rates by the rest of the world except perhaps China (which is beset by its own unique/unknown economic problems) in response to the inflationary trends. Standard economic theory dictates that if too much demand chasing too few goods is the reason for inflation, then tighten the supply of money so that demand moderates and inflation is thus tamed.

While this may be true of the US, UK and the Euro region, the Indian price rise is a different story altogether. In the Consumer Price Index, used as a proxy for inflation in India, food items have a weightage of 45 per cent, not to mention fuel prices which are also mostly “supply-based” and not “demand-driven”. In combating this price rise, increase in interest rates may at best have a peripheral impact. In India itself, it could be argued that the two-phase reduction in duties on petrol and diesel by the Union Government and the subsequent “freeze” on pump prices, did more for putting the lid on CPI than the increase in repo rates.

In the coming days, this “third shock”coming from beyond our boundaries, may well be the X-factor that would dictate our domestic interest rate movement though the cause-effect dialectic will be a derivative and not so direct as we would like to acknowledge.

(The author is a commentator on banking and finance. Views are personal.)