Crude prices and US rate are the X factors

RBI Governor Urjit Patel may be able to cut rates but only later this year. We take a look at what this would mean for the Indian economy. When will Reserve Bank of India (RBI) Governor Urjit Patel cut interest rates Speak to analyst, economist or businessman; that will be among his top two or three concerns. The background The central bank dashed hopes for a rate cut in December when the six-member Monetary Policy Committee (MPC), which sets rates, decided to retain the repo rate, the rate at which the RBI lends to banks and the key rate that banks use as a benchmark for the lending and deposit rates, unchanged at 6.25 per cent. The apex bank adopted this hawkish stance despite retaining its March-end retail inflation projection at 5 per cent. It, however, cautioned that high oil prices and rising interest rates abroad could once again fan inflation. Growth to slow down The RBI has cut its growth forecast for 2016-17 to 7.1 per cent, down from its earlier estimate of 7.6 per cent in a clear indication that the government's bold demonetisation initiative, though positive in the longer term, will crunch growth rates in the immediate term. Consumer spending down The festival season, beginning with Diwali in October and ending with the end of the wedding season in March usually witnesses a peaking of sales of consumer durable items such as cars, TVs, refrigerators and other such high value items. But the latest data shows that consumer durables output declined to a minuscule 0.2 per cent in October, down sharply from 14 per cent the previous month. The data also shows that consumers spent less on eating out, most likely due to the ongoing cash crunch. This trend is likely to persist over the next couple of months as the demonetisation initiative continues to take a toll on spending and the weekly and daily limits on cash withdrawals cap discretionary spends. Banks pass on some rate cut benefits Most economists agree that lowering rates and forcing banks to pass on the benefits to consumers could lead to a loan-fuelled consumption boom that, in turn, could increase demand and set off a virtuous cycle of growth, investment, job generation and consumption. With the banking system being flush with funds following the demonetisation-induced deposit rush and a nudge from the Prime Minister, many banks, led by State Bank of India, the country's biggest lender, have cut lending rates by 0.90 per cent. Other banks like HDFC Bank, Andhra Bank and a few others have also cut their lending rates in line with the repo rate cuts by RBI since the beginning of 2016. These banks have, thus, cut their lending rates by 200 basis points (bps; 100 bps = 1 percentage point) and now charge their prime customers interest rates in the range of 8.60-8.75 per cent. Room for more Analysts, however, say that the real sweet spot for interest rates - at which consumers are likely to come out in droves to buy houses, cars, TVs and other items - is the 7.5-8.0 per cent range, ie, another percentage point lower than the rates now being offered by most banks. For that to happen, Urjit Patel and the MPC have to lower the repo rate from 6.25 per cent at present by another 1.0-1.25 per cent at least. But can he Patel's perspective RBI Governor Patel has two mandates that are completely at odds with each other. On the one hand, it has to keep the inflation rate under control, since a rise in prices hits the weakest the hardest, also crowds out investment and hits growth. The tool to keep inflation in check is to keep interest rates high to check wasteful consumption. On the other hand, RBI also has to ensure that the economy continues to grow at a healthy pace to ensure jobs and prosperity for all Indian citizens. The way to do it is to lower interest rates to encourage debt-fuelled discretionary spending. These two mandates, obviously, contradict each other, but they're not mutually exclusive. The job of the MPC, then, is to find the equilibrium between these two opposing demands. Rising crude prices Even as falling growth rates increase the pressure on Patel to cut rates to encourage investments and spending, he will also have to keep one eye sharply focused on the Middle East, where Saudi Arabia and Iraq, which supply 40 per cent of India's crude, have decided to end the world's two-year honeymoon with soft oil prices, by cutting output and increasing prices. This is a clear signal that oil prices, which have been on the rise for the past few months, will increase further. Since India imports 80 per cent of its crude requirement, this will, obviously, have an impact not only on inflation but also on the balance of payments account, the fiscal and current account deficits and the value of the rupee. Collectively, this will be inflationary in nature and will severely restrict the MPC's ability to lower rates. The Yellen factor Patel and the other members of the MPC will also have to keep their eyes peeled on US Federal Reserve Chief Janet Yellen's moves. After keeping interest rates unchanged at near zero since 2008, the Fed increased its key policy rate by 0.25 per cent recently and signalled further increases in the months ahead. This could lead to a flight of dollars from emerging markets, including India, and cause turmoil in the currency and stock exchanges, bump up the price of dollars (and other hard currencies), increase the cost of imports and fuel inflation. One just has to hark back to what happened in August 2013 to visualise what might happen in a worst case scenario. The rupee had fallen to a record low of 68.85 against the dollar and 100 against the British pound, inflation had leapt up and the current account gap widened beyond the 5 per cent mark, almost bringing the Indian economy to its knees. The saving grace The economy is a lot stronger now and as former RBI Governor Raghuram Rajan reiterated several times, is well positioned to handle such shocks in the future. The broad metrics - fiscal deficit, current account deficit, wholesale inflation, retail inflation, tax buoyancy and GDP growth rates are all in a comfortable zone. During November, India's wholesale inflation rate fell to 3.15 per cent, down from 3.39 per cent the previous month. Though it was sharply higher than the rate of (-) 2.05 per cent in November 2015, food inflation, which affects the ordinary Indian most, recorded a steep fall, from 5.55 per cent in November 2015 to 1.25 per cent in November 2016. Retail inflation, likewise, also fell sharply from 4.2 per cent in October to 3.63 per cent on November. Push for growth Despite the global headwinds, Patel and the MPC also have a domestic imperative to push growth. Patel has indicated that he is inclined to accommodate this line of thought. Economists and analysts will be praying that OPEC's decision to cut output and raise premiums on crude oil does not lead to a massive spike in global oil prices. They will also be hoping that Yellen's bark is worse than her bite and that foreign investors take into account the inherent strength of India's economy when deciding on safe havens for their funds. If the impact of these two X-factors - global crude prices and US rate hikes - remain moderate, there is every reason to expect RBI to cut rates by up to 100 bps after a lag of about a quarter. If that happens, achieving a GDP growth rate of 8 per cent and more will be that much more attainable.