'RBI needs to encourage capacity expansion'

Stuart A Davis, the chief executive officer at HSBC India, expects the Reserve Bank of India to increase repo and reverse repo rates by 25 basis points in its quarterly monetary policy review on July 27, as concerns over accelerating inflation and uncertain monsoon linger.

Edited excerpts of an interview with Sumit Sharma:

What are the main challenges that RBI needs to take cognisance of for its quarterly monetary policy?

The main challenge before RBI at this juncture is management of inflation and its expectations.

Headline inflation has been in double digits, and core inflation at 7.3 per cent is above RBI's stated comfort zone of five-six per cent.

The central bank is fairly concerned about the possibility that the supply-side inflation of the first few months of this year could turn into a more generalised inflation.

At the same time, the uncertainty introduced by monsoon and global commodity prices would have to be watched closely.

These are factors which are difficult to predict and the policy stance will have to be one which takes cues from these external developments on an ongoing basis.

RBI would have to keep an eye on the growth environment as well, given that the run of economic data from the US has been taking a turn for the worse of late.

The global economy is recovering and the Indian economy is rebounding after the global slowdown. What does RBI need to do to keep growth on track while ensuring there is no overheating?

There are signs of capacity constraints emerging in the industrial sector, which could potentially lead to more pricing power in the hands of industry, and therefore, to more generalised inflation.

The environment which needs to be fostered is one where capacity expansion is encouraged.

Monetary policy assumes an important role in influencing capacity expansion decisions as the financing cost is a key input in the decision-making process for such projects.

It will be important to base policy decisions increasingly on the developing economic and financial environment.

RBI has raised rates thrice since March. How much of an impact have these rate increases had on the desired objectives?

The first few rate hikes were intended at a calibrated exit of the accommodative policy stance that was kept in place during the financial crisis period; and the signalling effect was well received.

There has been further implicit tightening in the system as overnight rates have been trading at the upper end of the liquidity adjustment facility corridor for the last five-six weeks.

Monetary policy typically acts with a lag, therefore, we will see the effect of the policy steps over time.

The global growth scenario is in a state of flux at this time, with some analysts predicting a double-dip recession in the US.

The financial troubles in the euro zone are well documented by now, and even China is showing some signs of a potential downtick in the growth momentum.

Indian government officials have been indicating a preference for economic growth to be over the 8.5 per cent mark.

The still evolving global scenario and the government's reliance on strong growth mean RBI will continue to maintain the balance between tackling inflation and supporting growth.

How much increase in rates can we expect in the review?

Given the concerns surrounding inflation and while the monsoon uncertainty still lingers, we expect that RBI will hike reverse repo and repo rates by 25 basis points in the upcoming policy review.

How much of a concern could overseas inflows become as India raises its rates? What measures could India initiate?

If we were to go by the current liquidity environment and the widening current account deficit for the country, overseas inflows would possibly not be a source of worry for RBI at this time.

The current account deficit for this year is expected to be around 4.5 per cent of the gross domestic product, which would be one of the highest in the world and the largest ever for India.

In such a scenario, overseas inflows would help ease the situation both on current account and liquidity fronts.

The answer to the widening trade deficit probably lies at home, where tighter monetary policy will restrain domestic demand and imports.

Where do you see repo and reverse repo rates by October?

If the external environment develops along expected lines, we would expect RBI to stay on the path of gradual tightening.

We expect the reverse repo at 4.5 per cent and the repo at six per cent by October this year.

Image: Stuart A Davis