RBI’s Steeplechase with Cyclical and Structural Hurdles

In what may be considered as capitulation toward accepting that the elephant named inflation is not yet in the woods, RBI’s latest assessment cautions against a hasty relapse into monetary accommodation.

The conviction around India being insular to lower global growth and, in a take-off, stage has also mellowed as the RBI sees downside risk to growth from declining corporate profits and reduced government spending.

Concerns are also compounded by the lack of counter-cyclical buffer in the banking system with the credit-deposit ratio (CDR) close to the peak levels of 77.4% and lagging deposit accretion, which makes rate easing inconsistent; it will take an estimated INR 6-7tn adjustment of CDR to realign to the equilibrium. As the RBI intensifies its regulatory tightening, the banking sector will need to negotiate with slower growth, lower margins, and rising credit costs.

RBI has scaled down its real GDP projections for FY25 with real GDP growth to 7.2% vs 7.3 earlier; 1Q at 7.1% (7.3% earlier). However, the cumulative impact of the aforesaid factors could imply further scaling down of growth projections.

Following its earlier research (Are food prices the “True” core of India’s inflation, Jan’24), RBI has weighted more strongly towards the persistence of high food inflation (8.4%), overriding the decisive moderation in core inflation to 3.1%, the lowest in 12 years. The central bank is also concerned about the recent spurts in prices of Milk and Mobile tariffs, which can permeate into broader inflation impetus.

Persistently high food inflation is out of sync with the recently published Consumer Expenditure Survey (HCES 2022-23) which suggests that the proportion of food consumption in household spending has declined over the past 13 years. We have shown why such assumptions are misplaced; the persistence of high food inflation is linked to rising ruralisation, falling real income, and the presence of the Giffen Goods phenomenon leading to higher demand for food even as income constraints resulted in downtrading in necessary goods. These explain the conundrum of high food inflation and softening core inflation that the RBI is facing.

Given the changed structural context of declining average real income growth to a 40-year low, the current lower headline inflation continues to hurt households. The central bank should aim for inflation below its outmoded target of 4% adopted in 2016. RBI’s projections for FY25 at 4.5% remain above the five-year CAGR in nominal wage per worker at 4% FY24 (-1.6% in real terms, RBI, KLEMS 2023-24), which weighs on households.

Based on our assessment that food consumption has risen instead of a decline, a recast of CPI weights based on an erroneous interpretation of the CES data in an attempt to lower headline inflation can pose a risk to macro stability. Hence, RBI emphasising the persistence of food inflation as a policy indicator is a caution against such potential miscalculation.

While the RBI emphasises the high level of capital adequacy and low GNPA ratios of Indian banks (16.8%, 2.8%) and NBFCs (26.6%, 4%), there are some imminent structural and cyclical risks.

Banks face structural liquidity problems because of continued slack in deposit growth (11.7% in Jul’24 vs 15.1% in Jul’23, ex HDFC merger), thereby pushing them to rely on short-term bulk deposits to meet the incremental credit demand, resulting in a peak level of CDR. This Asset-Liability (ALM) mismatch has compelled RBI to nudge banks to lower CDRs and take direct measures to increase the Liquidity Coverage Ratio (LCR) by 5pp on both bulk and retail deposits.

While retail lending growth has slowed from 21.3% (Jul’23) to 16.6% (Jun’24) on the back of regulatory tightening by the RBI, it is still at a very high level as uncollateralised lending continues to fund household consumption, hence subject to significant default risk against the backdrop of falling household incomes.

Home equity loans or top-up loans on various assets (gold & others) lack adequate monitoring by lenders, thereby exposing them to default risks from funding speculative activities.

RBI’s concerns about the banks are rooted in the structural problems of declining household incomes, funding the consumption gap through personal loans, and potential capital gains from speculative investments funded by bank loans. Thus, while the lagging deposit growth at the peak CDR is impairing growth prospects, the quality of existing retail leverage exposes banks to rising credit costs, specially if financial markets turn volatile.  Hence, as the RBI nudges down the retail leverage through regulatory tightening the extant financial stability can turn into fragility.

The dissonance between the objectives of growth, price stability, and financial stability is underpinned by both structural and cyclical constraints.

The structural characteristic of high food inflation is a function of higher food consumption arising from falling real household income (Giffen goods feature), hence having little sensitivity to monetary policy actions.

The continued decline in real wages despite enlarged post-pandemic government spending (31% of GDP from 26.7% in FY19) reflects the lack of crowding in the impact of fiscal expansion on private capex and employment generation. Hence, with corporate profits declining following the post-pandemic bounties, fiscal moderation and a decline in leveraged consumption could align growth towards structurally low levels; core real GDP growth (ex-discrepancy) in FY24 is estimated at 3.8% vs headline at 8.2%. The efficacy of counter-cyclical monetary policy, hence, also stands diminished.

The growth constraints lenders and banks face are a fallout of declining household income and savings associated with a high level of the effective unemployment rate at 28.3% (including disguised unemployment), contracting labor productivity, and real wages, which are outside the ambit of monetary policy.

Borrowing from RBI Gov Das’s style, we think the adapted version of Robert Frost’s poem “Stopping by the Woods on a Snowy Evening” is apt; Woods are lovely dark, and deep, but the RBI have promises to keep, and miles to go before it sleeps.

Indeed, cautioning the markets against premature rate easing, the Governor ends his statement by saying that “the slightest error of judgement, a hasty action or a hasty work may put back the hands of the clock of progress. Policies have, therefore, to be cautiously evolved”.