Over the past one year, the RBI has embarked on an ambitious inflation management programme, raising key rates consistently, but with little success so far. A sustained continuation of monetary transmission into higher lending rates could impact both consumption and investment demand
The Reserve Bank of India (RBI) on Thursday raised its short-term lending (repo) and borrowing (reverse repo) rates by 0.25%, clearly choosing inflation control as its main focus that would certainly have some downside risks to economic growth. According to economists and industry experts, the move will put further pressure on financial institutions like banks, to increase deposit rates as well as auto, home and commercial loans.
"While inflation control may remain their (RBI's) bias, growth rate below a threshold will also worry them," said KVS Manian, group head for consumer banking at Kotak Mahindra Bank. "The latest figure on auto sales, general trends in home sales and the preliminary direct (advance) and indirect tax numbers do not allow us to dismiss growth worries. And lastly, given the global commodity prices, there may be a new normal to inflation and it may not entirely be controllable by monetary policy."
In its monetary review, the central bank, however, kept its cash reserve ratio (CRR), the cash which banks are required to keep with the RBI, and the bank rate unchanged. The repo rate now stands at 7.5%. The reverse repo rate will be 100 basis points (bps) lower than the repo rate at 6.5%.
Amar Ambani, head-research for private client group at India Infoline, said, "The RBI raised the repo rate by 25 basis points (bps) to 7.5%, choosing price stability in the growth-inflation trade-off. China raising rates too added credence to the RBI decision to hike rates further. While the news seem factored in the market pricing, we see pressure building on consumption plays, autos and select banks too."
Despite 425 bps of effective tightening, inflation, as measured by both the wholesale and consumer indices remains elevated at over 9% levels. "While, so far, there is not a great deal of moderation in credit growth and industrial activity, especially in the light of the revamped Index of Industrial Production (IIP) data, a sustained continuation of monetary transmission into higher lending rates could impact both consumption and investment demand," said Deven Sangoi, head for equity, Birla Sun Life Insurance.
The RBI said it expects the policy action to contain inflation and anchor inflationary expectations by reining in demand side pressures and mitigate the risk to growth from potentially adverse global developments. "The monetary policy stance remains firmly anti-inflationary, recognising that, in the current circumstances, some short-run deceleration in growth may be unavoidable in bringing inflation under control," the central bank said.
Sonal Varma, vice-president and India economist at Nomura, said, "In our opinion, this tug-of-war between growth and inflation will intensify. The slowdown that started with industry and weakened investments is feeding into services with moderation in consumer durables. Despite more than 400 bps of effective tightening over a 14-month span, the wholesale price index (WPI) inflation has remained high at 9.1% year-on-year (y-o-y) in May, compared to 10.5% a year ago, raising the question of why rate hikes have not yet been effective."
The RBI has been waging a war against inflation, but its year-long efforts don't seem to be having the desired impact. On the other hand, there has been some moderation in the economy. During the January-March quarter, the gross domestic product (GDP) expanded by only 7.8%, the slowest pace of growth in the last five quarters. At the same time, factory output-as measured by the IIP-grew by only 6.3% in April, as against 13.1% same period last fiscal.
Pradeep Jain, chairman, Parsvnath Developers, said, "Inflation continues to remain high despite the RBI raising lending (repo) and borrowing (reverse repo) rates. We request the central bank to make provisions so as to increase the supply in the market. These increases in key rates are having an impact on growth and the repeated rate hikes have led to dwindling investment, which in turn, has led to a slowdown in economic expansion." Mr Jain is also chairman of the Confederation of Real Estate Developers' Association of India (CREDAI).
Echoing this view, Anuj Puri, chairman and country head, Jones Lang LaSalle India, said, "Purchasing activity had already dropped visibly during the last tranche of interest rate hikes, and we will see a further drop in buyer interest now." Elaborating on the effects of the latest rate hike on the real estate business, he said, "The RBI's hiking of the repo rate by 25 basis points is far from good news for the real estate sector, especially in terms of housing. As for developers coming down on their prices to counter the negative effects of this hike, a lot depends on the financial ability of individual developers to hold on to their current pricing and risk losing sales till the situation improves. Developers with enough capital base are less likely to relent on pricing than smaller developers with an urgent need to sell their stock."
The rate hike would also affect the automobile industry, as it would dampen demand. Pawan Goenka, president, Auto & Farm Equipment Sector, Mahindra & Mahindra (M&M), and president of the Society of Indian Automobile Manufacturers (SIAM), told the Press Trust of India that the RBI's move will have a negative impact on the industry. "It (the rate hike) was expected... Now we would like to see how much banks pass the burden (on to customers)," he said.
Dilip Modi, president of the Associated Chambers of Commerce and Industry of India (ASSOCHAM), said, "High input prices, rising finance costs and global uncertainties are adding to the negative sentiment. All these factors, in a high interest rate environment, will most certainly put the brakes on new investments and put corporate India in a difficult position to maintain the growth momentum."
Over the past year, the RBI has undertaken a highly ambitious inflation management programme, raising key rates consistently, but the results are not really visible yet. There has been an effective increase of 425 bps from a low of 3.25% (reverse repo rate) in the January-March quarter of 2010, to the current repo rate of 7.5%. This clearly shows the limitations of the Centre in taming inflation and economist feel that the government also needs to take other strong measures, like ensuring a proper public distribution system for key food articles, and crack down on hoarders as a measure to control inflation.
Dr Veena Mishra, chief economist, Mahindra Group, said, "Domestic growth has clearly moderated compared to a year ago, but this is, in my view, more the result of policy inaction on the part of the government rather than the monetary actions of the RBI. Without further policy reforms, a stable 'high growth-low inflation' trajectory just will not materialize."
The RBI has been downplaying growth concerns, due to the continued upside risks of inflation. These emanate from an incomplete pass-through of fuel prices, a possible hike in coal and electricity prices and high commodity prices on a year-on-year basis. "WPI inflation has remained high at 9.1% y-o-y in May. One reason is that fiscal policy, by raising farm support prices and boosting rural incomes, is offsetting the impact of higher rates. Therefore, there is an asymmetric impact of tight policy, with investment falling, while consumption demand is less affected. Additionally, the WPI basket is dominated by commodities and even the RBI's measure of core inflation-non-food manufactured WPI-is a mix of input and output prices. So, unless commodity prices ease, inflation should persist," said Ms Varma from Nomura.
Economists and analysts suggest that a good monsoon and moderation in commodity prices, as well as the global growth outlook, would determine the RBI's policy over the next few months. A majority of them expect inflation to stay elevated till September and that the central bank will hike rates by another 25 bps on 26th July. The RBI may feel that if it cannot control commodity prices, it can cut pricing power by squeezing demand, however, for consumers, especially borrowers, it can only mean more bad news.
“The sector (automobile) is already reeling under pressure due to high input costs and rising fuel prices and the steady hike in interest rates will affect sales,” General Motors India vice-president (corporate affairs) A Balendran said
Mumbai: With the Reserve Bank of India (RBI) raising key interest rates by 25 basis points, automobile industry captains feel the move will further dampen demand in the auto sector of the country, reports PTI.
“No doubt, it (RBI’s move) will have a negative impact on the automobile industry. It was expected... Now we would like to see how much banks pass the burden (on to customers),” Mahindra & Mahindra (M&M) president, Auto & Farm Equipment Sector, Pawan Goenka told PTI here.
Mr Goenka is also the president of the Society of Indian Automobile Manufacturers (SIAM).
The central bank raised key interest rates by 25 basis points today, the tenth time since March 2010. The RBI has raised the short-term lending (repo) rate by 25 basis points to 7.50% and the short-term borrowing (reverse repo) rate by a similar margin to 6.5%.
“The market has already slowed down... This latest hike will further dampen the auto sector... It is a matter of concern,” General Motors India vice-president (corporate affairs) A Balendran said.
“The sector (automobile) is already reeling under pressure due to high input costs and rising fuel prices and the steady hike in interest rates will affect sales,” he said.
Auto major Fiat India also sees a significant impact on the sector.
“Going forward, the RBI’s initiative will hurt the auto industry by hitting sales. The industry is (already) under pressure and this fresh step will further aggravate the situation,” Fiat India president and chief executive officer Rajeev Kapoor said.
Rajkot-based three wheeler-maker Atul Auto also feels the rate hike will further affect demand. “Definitely, it will have an impact on the automobile industry. However, I am confident the industry will face this challenge boldly,” director Vijay Kedia said.
“Things like high inflation, rate hikes and the fuel price increases point out to a tightening in the situation,” he said.
According to SIAM, total sales of vehicles across categories registered a growth of 13.40% to 13,70,786 units in May, as against 12,08,820 units in the same month last year.
How inflation, economic growth and stock prices are interlinked
Markets are influenced by human behaviour acting in herds; so it is tough to formulate laws that can explain market action, much less predict it accurately. But Ed Easterling has an interesting theory which he calls ‘financial physics’. Financial physics explains the interaction among the principles of economics and finance as the drivers for secular stock markets. In the financial physics model, two elements of economics—economic growth and inflation—drive the two financial components of the stock market, viz, corporate earnings and stock prices.
In the first set of correlation, economic growth is the fundamental driver of earnings growth which, in turn, is the primary driver of the stock market over the long term. Higher growth and higher inflation should increase corporate earnings. If inflation only bumped up earnings, the stock market would respond accordingly and move higher; but it does not.
This is where the second factor comes into play. While inflation increases earnings, it also affects the price levels of financial assets and the price level of a financial asset influences subsequent returns. Rising inflation increases the level of returns required by investors, thereby causing prices to decline. Stock prices fall as the present value of future earnings declines. To get a higher rate of return from stocks, investors tend to pay a lower price for future earnings (i.e., lower P/Es). In effect, inflation drives down P/E and, thus, offsets the inflation-driven growth in EPS.
Historically, the years with higher inflation and deflation tend to have a low P/E. When inflation is high, investors should expect that P/E would be low. If we are in a situation of higher-than-average-P/E, prices will fall—often, despite growing GDP and earnings. Similarly, in a scenario of deflation, the future growth rate for earnings and dividends turns negative and the value of stocks falls. Thus, both higher inflation and deflation cause P/E to decline. Higher inflation also reduces the purchasing power value of an investment portfolio. Thus, high inflation brings in low returns and lessens the value of what’s left. Easterling’s market valuation theory firmly makes the market level relative to the inflation rate—not a level that is arbitrarily anchored to a long-term average. This is precisely what is happening in the market today.
There are fears of rising inflation which are reflected in P/E compression—despite rising EPS (earnings per share) and GDP growth.