Tighter financial conditions may not squeeze growth
PremiumGrowth prospects have turned bleaker globally but higher interest rates in India are likely to play a less significant role in hurting domestic demand and economic growth this fiscal year
The Reserve Bank of India (RBI’s) Monetary Policy Committee has raised the repo rate by 90 basis points (bps) so far in 2022 and we expect a further increase of 75bps this fiscal. Withdrawal of surplus liquidity, which began gradually last August, has gathered pace lately. The flight of foreign capital from asset markets has also led to a tightening of domestic financial conditions. Continued rate hikes amid high inflation, heightened uncertainty and tightening monetary conditions globally, and further flights to safety suggest financial conditions in India can only get tighter from here.
Tighter conditions in 2022 were expected, as central banks—including RBI—dialled back easy-money policies. The shock waves of the Russia-Ukraine conflict accelerated this process in response to rising inflation.
Crisil’s Financial Conditions Index (FCI), which tracks movement across equity, debt, money and foreign exchange markets, as also policy and lending conditions, shows steady tightening of overall financial conditions in India in recent months. The key question is: Will this hurt the green shoots of growth?
Our economy is faced with an increase in borrowing costs after three years of falling interest rates. Most people recall the 115bps reduction in the policy repo rate announced by RBI to prop up the economy during the pandemic. But monetary policy easing began in February 2019—well before the pandemic hit—and rates were on a decline, given low inflation and the need to support growth.
Between February 2019 and May 2020, the repo rate saw a cumulative reduction of 250bps from a high of 6.5%; RBI also pumped in liquidity between March 2020 and July 2021 to ease availability of funds during the pandemic. Excess liquidity averaged ₹4.7 trillion each month during that period and helped bring down short-term interest rates by 140-180bps across instruments compared with pre-pandemic levels.
A lot has changed since then. Growth is recovering gradually and an inflation surge has necessitated monetary policy action. Compared to a year ago, short-term interest rates in the money market are now 80-200bps higher across instruments, while the 10-year government bond yield is 135bps higher on average due to RBI actions and elevated government borrowing. A rise in borrowing costs is the last thing an economy would want in a scenario of weak growth. But this is what’s playing out. Globally, rising borrowing costs are expected to slow growth in the coming quarters. In the US, for example, the Federal Reserve’s tightening cycle foreshadows a slowdown. Growth prospects have turned bleaker. In India, however, higher interest rates could play a less significant role in hurting domestic demand and economic growth this fiscal year.
For one, rising interest rates impact the US economy more than India’s, given the former’s greater dependence on credit (domestic credit is about 216% of gross domestic product for the US compared with about 55% for India). In India, there will be some impact on highly interest-rate sensitive segments, but the overall impact on the economy will come with a few quarters’ lag and should be relatively low. We expect RBI to front-load its rate hikes in 2022-23. Their peak impact may thus be seen towards the end of this fiscal and the next.
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Secondly, though interest rates are rising in India, they are below pre-pandemic levels for several instruments (including repo and bank lending rates), while availability of credit remains comfortable. Even after the expected trajectory of 2022-23 rate hikes, a repo rate at 5.65% will be much lower than the previous peak of 6.5% seen in 2018. In contrast, the US is likely to see larger hikes. S&P Global expects the Fed funds rate to rise to 3-3.25% in 2023, higher than the level of 1.5-1.75% in February 2020 and the highest since early 2008. Lending rates in the US are already on an upward spiral and hurting growth. While banks in India are also charging more, their rates remain lower than pre-covid levels as well as relative to the past decade.
Third, the real repo rate’ (minus inflation) has been negative for more than two years, indicating relatively easy monetary conditions. RBI’s rate hikes will at most narrow the negative gap with inflation by end 2022-23. A 2013 RBI paper shows that real rates influence growth.
Finally, another aspect that differentiates India from the US is that while the cost of funds is on the rise, supply so far has not been constrained. Bank credit growth is rising, driven by improving demand, and reached its December 2019 level in April.
Crisil’s FCI shows that conditions have gradually been tightening since November 2021. External headwinds are expected to get stronger in the coming months as major central banks hike rates to combat inflation. Net-net, conditions are expected to move past the dream run seen in the past two-three years.
Yet, overall financial conditions are not significantly tight relative to the past decade, by and large. They are also not expected to tighten to the extent that creates headwinds for growth. While segments such as money and bond markets, which benefitted more from pandemic policy easing, could feel a greater pinch as easy liquidity gets withdrawn, negative real interest rates and improving credit offtake will lend support.
Other factors, such as surging inflation and slower global growth, could pose bigger headwinds to domestic growth this fiscal.
These are the authors’ personal views.
Dipti Deshpande & Pankhuri Tandon are, respectively, principal economist and economist at CRISIL Ltd.