Are the decks clearing for an rbi rate hike

Are the decks clearing for an rbi rate hike

The bank recapitalisation plan has stirred a debate on whether it would make RBI amenable to a rate cut, but that may not be the case

The government’s mammoth recapitalisation plan for beleaguered public sector banks has stirred a debate on whether it would make the Reserve Bank of India (RBI) amenable towards a reduction in policy rates.

After all, one of RBI’s biggest arguments against rate cuts was the weak transmission to bank lending rates that stemmed from their stressed asset pile. In every way we look, the Rs2.11 trillion bank recapitalisation plan is but the last leg of the banking sector’s clean-up exercise that began two years back when the central bank called for a complete disclosure of stressed loans and provisioning for them.

Since then, the bad loan pile at public sector banks has swelled to above Rs8 trillion for which they have provisioned around Rs3.5 trillion as of June. Since most of the lenders are swimming naked with poor provision coverage ratio along with no internal accruals for capital, much of the capital infusion would go towards fixing the balance sheet. This would happen over two years, giving enough time for lenders to gear up for credit demand from companies.

Recall that RBI’s grouse was that rate cuts would be pointless given the reluctance of banks to pass on the benefits to the real economy. Now that the government has remedied this, it should improve monetary transmission. What better way to boost growth than to give it a shot of interest rate cut, especially when banks will be willing to pass this on?

However, it is not that simple. For one, the whole process of capital infusion would be over eight quarters. Responding to a long-drawn process prematurely with a rate cut boost before the results are obvious would be foolish. In RBI’s own words, bank recapitalisation is just a support mechanism when investment demand revives.

Second, RBI governor Urjit Patel hasn’t disregarded the fiscal implications of this infusion. In his statement, Patel says that the plan will front load capital injection but stagger the fiscal implications over a period of time.

And lastly, the capital infusion does not materially change anything on the inflation or the growth front immediately. But along with the capital infusion, the government also announced an investment of Rs7 trillion over five years to build roads. This could nudge awake a slumbering investment climate and in turn spur growth. That sits conveniently with RBI’s bullishness on growth recovery in the second half of the fiscal year. The added fillip to growth will most certainly keep up the pressure on core inflation.

That gives currency to hike, not cut policy rates. Goldman Sachs believes so as it is forecasting three hikes by the end of 2018.