RBI's stance should be to keep the rupee more volatile: Neelkanth Mishra

The big question on everyone’s mind is, will the growth that we have seen in the first half of FY25 slow down? How much of this is a structural problem? How much of this is because of cyclical issues? We believe that almost all of this slowdown is because of cyclical issues. Trend growth remains at about 7%. What happened in the first six months of FY25 is an incredibly tight fiscal condition; generally in the first six months, the central government incurs about 62% of its full-year fiscal deficit. This year, it incurred only 29%... fiscal tightening is very bad for growth… 33% of 4.9% of GDP, which is the target fiscal deficit for this year, means that 1.6% GDP worth of fiscal consolidation was squeezed into just six months. Almost all of it was unintended… We expect that as the government catches up and meets its fiscal deficit target for the year, the tailwinds from that should support the economy in FY26.

There was a second driver of the cyclical slowdown, which was the problem with the credit impulse. So, as we have seen, 17% credit growth has now fallen to below 11%. Some of this was intended. The Reserve Bank of India (RBI) was rightly concerned about unsecured personal loans and microfinance loans being too high. But in the process, the credit slowdown has become much more broad-based. If credit growth slows from 17% to less than 11%, the economy is bound to slow down. On this as well, we expect that some corrective measures are underway… CRR has been cut. I think the `1.16 lakh crore of liquidity that we have been seeing, once you apply the money multiplier as well, it will add `5.5 lakh crore to overall liquidity and can support 3-3.5% growth in overall credit formation. We expect that as the year progresses, we should see a steady improvement in the economic momentum and FY26 should be closer to 7% real growth.

Do you see any sector doing well from overall government spending? We’ve seen capex being one of the key drivers… What is enabling this aggressive intent?

There is no aggressive intent. What we have just seen is that because of the elections, the file movement has slowed down. If you recall, elections this year were one month later than usual. So, while in any election year, there is some disruption to government functioning. This year, it was much more delayed. So, the biggest slippage versus normal fiscal spending occurred in May and June. And because this was kind of the pattern of government action was very different. The 1.6% of GDP worth of unintended fiscal consolidation in the first half would be reversed in the second half and that could become a tailwind for the rest of the economy.

Do you expect a new rate policy? And if so, when?

On the interest rate side, I don’t think the RBI’s Monetary Policy Committee has much room to manoeuvre. In fact, what we also highlight in our report is that we expect inflation to remain elevated for much of FY26, and therefore the MPC may not be able to cut rates… Food inflation has been surprising steadily on the upside and there are many factors that I think are at play.

The first is that the income transfer schemes that 14 states are running are in total about `2 lakh crore a year at an annualised rate and given that they are targeted at the bottom 40% of the population, the impact is the biggest on the demand for food... This already is `2 lakh crore, and by the time most of the states are done with it, I think it will be closer to ` 3 lakh crore. So, the impact on low-end wage rates that then feed into labour-intensive crops like vegetables can also be quite meaningful. So, I think the interest rate environment is unlikely to change much. There may not be enough scope… I don’t think there will be enough scope for rate cuts to happen.

I think the challenges emerge on the quantitative side so there is cost of money in the interest rates… And for nearly one-and-a-half years, the central bank’s injection of money into the economy was well below normal. And a very large part of the money creation was then being done by the commercial banks. And as a result, credit growth was way higher than deposit growth.

[From the] beginning of FY25, RBI started becoming uncomfortable that the loan deposit ratios in many of these banks had become very high. And they instructed the banks to bring it down… That process, I think, with the cut in the CRR, is starting to get reversed, because then there is a structural change in the money available for banks to lend over a period of time.

Once the banks realise that there is less competition for deposits and that they are not going to get slapped on the wrist for growing their loans, the credit impulse in the economy will be positive from being very strongly negative.

You talked about the stimulus amount going up because of welfare schemes. Does it have implications for the manner in which interest rates are set and the mandate that is given to the MPC? I also refer to arguments that talk about carving out food prices from the overall inflation basket.

At this stage [it] is a somewhat theoretical argument. There is a law that states that the MPC needs to target headline inflation and unless that law is amended, the discussions around this are completely academic… The bigger question is that the impulse on the inflation side because of these income transfer schemes at an aggregate level may not be as intense or as large as what we saw in the 2011-13 period because these schemes are being funded through expenditure switching.

The question to ask from a macroeconomic perspective is where is this `2 lakh crore coming from? Is it coming from higher taxes, is it coming from higher deficits or is it coming from cutting expenditure somewhere and spending it on these elements? This trend varies from state to state but at an aggregate level it does seem to us that the expenditure to GDP—if you compare FY19 to FY25 Budgets—is not really going up in most of these states. Which means that they’re cutting some other expenditure to finance the schemes. And I think the underlying reason is very strong, which is that state governments have a 3% of GSDP cap, which the central government enforces… And hence the aggregate inflationary impact, which is an 8-10% kind of inflation that we saw 10-12 years ago, is unlikely to happen.

Do you expect quantitative easing to continue?

Too much is not warranted, meaning that the money creating levers in the economy should be unrestrained, but active injection of liquidity at this stage, other than to counter whatever is happening on the forex side, may not be necessary. Financial theory says that you cannot manage both the cost of money and the quantity of money to the last mile or the last point, together; meaning that both are interconnected. Money supply is endogenous, meaning the economy kind of creates its own money. For example, as people demand more credit, and banks give that credit, money is created. [In the] overnight money market, when credit growth is strong, things go into deficit, the central bank makes available the money. So, in a way there is a demand angle here as well. You cannot try to control both at the same time. But at the same time, you need to be conscious that the central bank injection of money, if it is not happening adequately, can be changed.

Till 2022, CRR was at 4%... and the economy was creating sufficient money. In 2022, when liquidity went into surplus, the central bank raised it to 4.5%, [and] perhaps bringing it down was necessary. And now it has happened… once the CRR cuts are in place, if the liquidity remains in deficit and the things in the overnight market are still very tight, they [the central bank] may need to do open market operations to inject more liquidity. But I won’t call it quantitative easing.

What’s the outlook for the rupee?

One recommendation is that the rupee should be allowed to be more volatile. It has over the last two years been the least volatile currency in the world. There is some merit in having higher volatility, [but] having excessive volatility is very damaging for the economy, because there are many economic participants, small businesses, small investors who do not have the ability to forecast currency levels, global economy and therefore may end up paying too high a price for hedging their exposures… But if you have too little, then the central bank is taking over the responsibility of hedging effectively for the overall economy, which generally is not wise. And especially as we head into a period of significant volatility in currencies globally, it makes sense for the band in which the USD-INR moves to be a lot wider than what it has been in the past two years.

On the level of the currency, one last point is that there have been some exceptional outflows in the past two and a half months that are unlikely to be repeated or not be that intense in the next three months. So, there has been a significant amount of dollar-selling by RBI to protect the rupee from significant depreciation.

If President Trump’s first policy is the extension of tax cuts, the fiscal deficit in the US starts going up, there is an increase in 10-year US bond yields, there are more outflows from emerging markets, the dollar strengthens further, then the rupee can face some more pressure. A bigger issue is going to be what happens to the Chinese yuan (CNY), the renminbi. Chinese policymakers… have already signalled that they are preparing for a devaluation… if the USD-CNY was to rise further, then there would be a big question for the central bank as to, ‘do you really want the rupee to appreciate against the yuan?’ And this is not just the INR, every central bank in the world will have to ask themselves that question.

I must say though, that keeping the rupee more volatile should be the stance of RBI.

Will the new Trump administration’s initial salvos hurt or help growth?

There is some uncertainty on what exactly he will do… But what is clear is that he will respect that mandate… The first is that there will be checks on immigration. And I think the deportation that he has promised, deporting 11 million illegal immigrants, looks difficult… But there is very likely to be a slowdown in immigration.. Which means that some of the growth surprises that the US was showing—which was coming from higher labour force or faster growth in the labour force—will slow down.

There is a second element, deregulation… which is… in government hands. Financial sector deregulation, oil drilling deregulation, healthcare deregulation, all of these will potentially boost productivity growth for the US. On the fiscal side, the fact that he wants to extend the 2017 tax cuts that are expiring in 2025, will mean that the US economy gets some fiscal impulse and that could also be a growth positive.

Trump has continued to mention India and Brazil together with regard to tariffs. Do you see a shift required in our trade policy?

This is where I think many of the statements that we hear from the new US are starting points for negotiation. Even the threat of reciprocal tariffs… will mean that India may be among the worst affected, because India’s import duties are among the highest among the major economies. We have calculated that if it is just translation, it would be about $7.5-7.6 billion in a year, which is not small, but not shattering. So, should India’s trade policy be changing in anticipation? I think this will be a process of negotiation.

@szarabi