What should the RBI do in response to the Fed rate cut?

The most sensible response would be to give up control of the bond market to Sebi, rather than tinker with the repo rate

How should the RBI respond to the Fed rate cut?

How should Indian monetary authorities respond, when the US Fed cuts rates, as it is widely expected to? Respond in kind or hold tight till any resultant financial turbulence is over? Cutting the repo rate or raising it is much of a muchness, and the most constructive response on the part of the RBI would be to let go of the government bond market and let Sebi regulate it, along with other securities.

With an assortment of variable rate and fixed rate repos for varying periods, and frequent buying and selling of dollars and accompanying bond sale/purchase operations to neutralize the counterpart rupee impact, the repo rate has become just one another tool for guiding the money market rate to what the RBI thinks is the appropriate level. Of course, the repo rate has the maximum signalling capacity, and that is about all.

The RBI governor has already indicated that he does not think there is any need for India to hasten to cut rates in the wake of a US rate cut. Financial stability is a prime consideration, he said. This is a most sensible approach. It is another matter that the sensible approach to monetary policy elevates inflation-targeting repo rates to the level of the Vishnu Purana and other myths of the land. Given the current climate of glorifying the past, even figments of imagination from it, we should not be surprised if some people start approaching monetary policy with trepid veneration.

The US Fed rate cut might not result in a big, immediate gush of dollars redeploying to the Indian market, at least in the short term.

In all probability, the Fed’s Open Markets Committee will opt for a 25-basis point cut, rather than the 50-basis point cut that many have been hoping for. Inflation in the US is down to 2.5%, and the rate of unemployment has risen a tad to 4.2%, but the US economy has grown by a whopping 2.4% in the June quarter over a year ago. Growth has slowed down since, most probably, but there is no justification for the US Fed to give the impression that there is some kind a recession monster lying in wait, to clobber which it needs to wield a big rate cut.

Further, most probably a 25-basis point rate cut has already been priced in. The yield on 10-year government bonds in the US is 3.6%, down 64 basis points from a year ago. The US dollar index, which measures the currency against a basket of six other rich world currencies, not including the renminbi, is down from 106 in March through May to below 101 now. The Chinese currency is up 2.5% against the dollar, over a year ago.

Foreign funds have been pouring into India, and India’s foreign exchange reserves have climbed around $95 billion higher than the level a year ago. The latest reported figure is $689.24 billion. Funds are likely to continue pouring into India, even if not in the immediate wake of the rate cut, as India continues fast growth and Indians’ savings increasingly get financialized and find their way into the stock market, either directly or via mutual funds, keeping markets buoyant.

India does not have a current account surplus: it has a deficit, unlike China, the petro states, Japan and most other countries that have huge forex reserves. Therefore, India’s foreign exchange surpluses represent unabsorbed capital inflows, over and above what is required to pay for the excess of imports of goods and services over exports. India needs less unabsorbed capital.

Capital inflows into the stock market add to the liquidity in the system, and does not directly trigger fixed capital formation. Even foreign direct investment has the same effect of merely adding to the liquidity, if it results in a chunk of shares being transferred to a foreign entity from the Indian promoter, rather than directly creating new capacity or a new company. This additional liquidity might find its way into creating a new enterprise or new capacity or additional activity in an existing enterprise, provided it finds its way into the fresh capital being raised by a company expanding its capacity, either as debt or equity.

If the US rate cut and outward redeployment of portfolio flows into emerging markets, including India is to serve a useful purpose, rather than merely push up stock prices to unrealistic levels from which a sharp tumble is unavoidable, more of the liquidity must find its way into real capital formation.

For that companies need to invest more in new capacity or infrastructure. Right now, the government does the heavy lifting in infrastructure investment. The ruling party dubbed public-private-partnerships (PPP) in infrastructure, widely resorted to under the UPA, as tainted. While some of these projects did go sour and built up the non-performing assets of the banking system, most of them worked out just fine. The Delhi and Mumbai airports are good examples.

Stocks are getting overvalued. The additional liquidity pouring in must be utilized to build new infrastructure, not to inflate stock prices. A functional corporate bond market and a new PPP policy are vital to that end. Outstanding value of corporate bonds stood at 18% of GDP in December 2022, and 16% of GDP in March 2024. It is a multiple of GDP in developed markets.

The corporate bond market can grow only as part of an integrated, government plus corporate, bond market. Hence the expectation that the RBI would give up control of the government bond market.