It needs to be seen if the anticipated rate hike in October will encourage inflows and reduce exchange rate volatility
A month back, we had concluded that with the CPI inflation for Q2 FY2019 set to lag the monetary policy committee’s (MPC’s) estimate of 4.6%, the likelihood of a rate hike in the October 2018 policy review was low, in spite of the rupee having weakened to Rs 70.23/$ (RBI reference rate as on August 16, 2018).
Since then, as expected, the year-on-year (YoY) CPI inflation corrected to a 10-month low of 3.7% in August 2018 from 4.2% in July 2018, receding below the MPC’s medium-term target of 4% after 10 months. GDP growth printed at a higher than expected 8.2% for Q1 FY2019, followed by a healthy 6.6% expansion of industrial output in July 2018.
However, rising concerns about the impact of the impending US sanctions on Iran, have led to a surge in global crude oil and domestic fuel prices. This has contributed to an upward revision in the estimates of India’s current account deficit for FY2019, given the country’s dependence on imported fuels. The latter, in conjunction with weak global sentiment related to emerging market currencies, has resulted in the rupee recording fresh all-time lows. To curtail the weakness in the currency, the government announced several measures over September 14-16, 2018, which are intended to reduce the current account deficit (CAD), and boost financial inflows, particularly debt flows, to offset the CAD.
Contrary to expectations that the announcement of these measures would boost sentiment, the rupee has weakened further on September 17, 2018, with the operational details related to these measures being awaited from various ministries and the Reserve Bank of India (RBI), and in a reaction to global cues.
A weaker rupee has exacerbated the landed cost of various imports, including domestic retail fuel prices, raising concerns regarding the trajectory of inflation. The headline CPI inflation appears likely to range between 4.6-5% in Q4 FY2019.
Accordingly, we now expect a third consecutive rate hike in the October 2018 policy review, along with a change in stance to the withdrawal of accommodation, unless crude oil prices and the rupee record an appreciable reversal in the intervening period. Whether another rate hike succeeds in encouraging portfolio inflows and thereby reducing exchange rate volatility, remains to be seen. Reflecting various concerns, the 10-year G-sec yield spiked from 7.70% on August 1 to 8.23% intra-day on September 12, before easing to 8.10% on September 17. The latter partly benefitted from the announcement of an open market operation of a purchase of G-sec of Rs 10,000 crore by the RBI on September 14, and the market’s expectation of a pipeline of such OMOs in the remainder of this fiscal.
The market borrowing calendar for the central and state governments for H2, in addition to inflationary concerns and global cues, will keenly influence bond yields in the coming weeks.
The writer is principal economist at Icra
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