As the markets basked in the euphoria of the landslide mandate for the incumbent government, the focus now shifts to real macro issue grappling the economy. The first day of the new governments’ term brought in the reality check with the Q4 FY19 gross domestic product (GDP) growth slowing to a five-year low of 5.8 percent while the gross value added (GVA) growth declined to 5.7 percent from 6.3 percent in the previous quarter. Overall, the GDP grew 6.8 percent in 2018-19, lower than the previous year's 7.2 percent and is the slowest since 2014-15.

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While a decline in consumer demand, a slowdown in government spending and weak private investment have all impacted India's growth in the fourth quarter, the continued sequential moderation in quarterly growth and indication from several other high-frequency indicators such as automobile sales, rail freight, petroleum product consumption, domestic air traffic and non-oil, non-gold imports indicates that the slowdown in the Indian economy is quite well entrenched.

To add to this is the fact that exports are also not firing and unlikely to recover in the near future with the global macro environment turning fluid. Recent intensification of trade wars among large economies is threatening to undermine a nascent recovery in global trade. Economic surprise indices are decelerating while financial market volatility is on the rise. Though, global equity and credit markets reflect no rush for the exit, at least for now, the global fixed income markets are clearly ringing alarm bells. The average 10Y yield of G10 economies have fallen by around 40 bps since the start of the year of which 25 bps has happened in the last one month alone. Most of the highly tracked sovereign curve is fast approaching levels last seen in 2016 in the aftermath of Brexit which marked the all-time low. While our base case for the global economy is still that of a slowdown and not of a full blown recession, the sharp inversion of yield curve in developed economies have clearly raised the stakes for systemic central banks to ease decisively and forcefully.

With the above domestic and global backdrop all eyes are now on the RBI MPC meeting for its rate action, rate guidance and liquidity stance. There is a wide consensus among market participants, us included, that the MPC will ease the key policy rates by another 25 bps on June 6 and maintain the flexibility with a neutral stance. However, the additional piece of information would be on the voting pattern for the rate action as previous two rate action were taken with a split verdict. It’s evident that the perceived upside risk on the inflation which may threaten the MPC mandate of 4 percent inflation target on sustainable basis has not materialized while growth slowdown is deeply entrenched. The average CPI during the past twelve month is around 3.3 percent and is expected to remain well contained below 4 percent mark in the foreseeable future. The credibility of the MPC inflation targeting framework since its formation over the last three years is also established. This leaves the door open for RBI MPC to support the other objective of growth in a more meaningful way.

In the current context of growth inflation mix, both domestic and global, the debate over the need (or not) to maintain a high real rate in India is a pertinent question before MPC. The current real rate is well above 2 percent, factoring our in-house estimate for inflation around 4 percent by late FY20. Theoretically, high real interest rates are perceived as a driver for savings and deposit mobilization. However, hard data shows that despite a wide 300-400 bps of real rates in recent quarters, there has been no material pick-up in the banks’ deposits, lagging credit growth and raising concerns over a structural liquidity gap. We expect MPC to debate this question over the role of interest rates, in isolation, as a driver of savings behaviour in a capital starved country like India.

Markets are also watching for any flexibility from the RBI/MPC in the liquidity framework from the current stance of ‘neutral’ to ‘surplus’, keeping in mind the concerns on transmission. While we do expect that an explicit announcement on keeping liquidity surplus might still not be a part of the decision we do believe that the OMOs, FX swaps, expected return of currency in circulation and increase in government spending will anyway lead to a situation of surplus liquidity. A change in the liquidity framework might be initiated and considered separately after feedback from the real economy and the financial markets.

On the other issues, it’s heartening to see that the RBI under the new governor is living true to its first media address, where Dr Shaktikanta Das said that “consultations with stakeholders will become fundamental to the central bank's functioning in view of the complexity of modern day decision-making”. The proactive approach to address some of the bottlenecks in NBFC, development of housing finance securitization market, secondary market for corporate loans, PCA banks etc are all welcome development.

Given that the fiscal space for new government is likely to be a constraint, the near term weightlifting for acceleration in economic activities has to be done by the RBI. It might be worthwhile recalling the line written by the RBI governor in the last MPC minutes: “RBI will continue to watch the evolving growth and inflation dynamics and shall act in time and act decisively while ensuring price stability on an enduring basis”. We hope that time for decisive action has come.

B Prasanna is the head of global markets at ICICI Bank.

First Published:Jun 2, 2019 6:03 PM IST