In this blog, I attempt to read the mind of MPC (Monetary Policy Committee) of RBI to guess if the assessment of RBI regarding required real rate of return has changed to keep the Indian financial system stable.
The table below gives, for last six financial years starting on 1st April of respective years, what was the policy rate announced in the first MPC meeting alongwith corresponding one-year forward expectation of Inflation of MPC mentioned in the same document.
Table 1: Real Rates Expectations of RBI MPC
In the latest policy announcement last week, RBI expects one-year forward inflation of 3.65% (mid-point) and it has kept repo rate of 6.00%, meaning, overnight risk free real rate for Indian Rupee is now 2.35% in the minds of RBI MPC. (See the last row of Table 1). This real rate for Indian Rupee has increased from zero in April 2014 to 2.35% in April 2019.
Normally, we can justify such as increase in real rates earned in a currency if the macro-economic fundamentals have steadily deteriorated for that sovereign issuing that currency. However, during the period under the study, perceptions regarding India’s macroeconomic fundamentals have improved as seen by very low inflation by historical standards, stable fiscal deficit, stable currency, and increasing foreign exchange reserves. Imports of critical commodities like coal have fallen, while luxury imports have increased; steps are under way to substitute costly imported crude oil with either domestic ethanol or cheaper imported LNG to the extend feasible. Progressive opening of DFCs since Dec 2018 (and expected to complete by March 2020) will also move incremental transport sector growth from imported crude based diesel to domestic coal/solar/wind produced electricity to a large extend, meaning if the current economic policies continue, signs of structural external deficit from essential goods reducing in near future are bright.
Hence, there must be certain risks which RBI MPC is aware of which the market is ignorant of that is prompting RBI to steadily increase the real interest rates in the economy. Maybe we will learn about those risks in the years to come. At the same time, we hope that, the high real interest rates do not become a self-fulfilling prophesy, creating a credit crisis in the economy as businesses go under the yoke of one of the highest real rates in the G-10.