The Reserve Bank of India has raised the repo rate and shifted its stance to “calibrated tightening”, signalling that rate cuts are unlikely even as future policy decisions remain data-dependent. But what does this mean for inflation, growth, borrowing costs and liquidity in the banking system?

In this episode of How India’s Economy Works, journalist and author Puja Mehra speaks with Madan Sabnavis, Chief Economist at Bank of Baroda, about the RBI’s latest monetary policy decision. Sabnavis explains why he had argued for delaying the rate hike, why he expects further increases, and how the RBI could manage the large surplus liquidity created by FCNR deposits.

They also discuss India’s dependence on foreign capital, the role of domestic savings in financing growth, why net FDI flows have remained lacklustre, and whether India can remain insulated from global financial conditions. Sabnavis also explains why economic forecasts are becoming increasingly dynamic as economists rely on high-frequency data and constantly changing global conditions.

Tune in for insights on interest rates, inflation, liquidity, foreign capital, domestic savings and India’s growth outlook.

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TRANSCRIPT

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Puja Mehra: Mr. Madan Sabnivas, welcome to the show. Thank you so much for coming.

Madan Sabnavis: Thank you for having me, yeah.

Puja Mehra: So, the RBI governor has just announced the latest monetary policy review, and as we record, his press conference is on. In fact, it may be at the FAG end of it. But what are your first thoughts about what has been done?

How does that compare with what was expected? This was an important monetary policy announcement. So, what was your expectation and what's it looking like, what they've announced?

Madan Sabnavis: You know, in fact, we had a fairly contrarian view. And the interesting part is that we as economists, the economics team of Bank of Baroda, we felt that there should not be any change in the repo rate, whereas management out here felt that, yes, it was probably time to raise the rates. So, it was a contrarian view, not just with other economists, but also in terms of the way in which our own bank looked at rates.

But that's anyway a thing of the past, because we felt that probably the timing of a rate hike is something which could have been deferred, the reason being that we had a plethora of deposits which came in on account of the HCNR scheme. So, whenever we talk of the efficacy of credit policy, the question is that how good is the transmission? So, while the transmission takes place fairly automatically when there are the EBLR loans, external benchmark linked loans, which are a concern, but when you're looking at the MCLR, it's, again, based on the cost of funds.

If you go back to the deposits, it's just a situation where banks would like to raise deposit rates at a time when they already have surplus funds with them. So, that's one reason why we felt that the rate hike would have been deferred. But we were all for a rate hike.

In fact, I think that for this particular rate hike cycle, going right up to 6% would be very, very appropriate, because if you're talking going by the RBI's forecast of inflation 5.1% for the year, if I have the repo rate at 6%, we're really talking of a real return of something, a real interest rate of something around 1%, which I think is fairly OK. I agree it should be around 1.5%, but 1% is good to begin with. The other thing was that this is the beginning of the festival season.

So, we just thought from the psychological point of view, not increasing the rates at a time of festival is something which could have helped in consumption. But, of course, whenever anybody is borrowing funds, that's the retail loans especially, one knows very well that if you're buying a home or a car, rates are based on something which is very flexible and linked to the repo rate, which means that if I have a tenure of 20 years for a home loan, there would be certain points of time when interest rates would go up at certain times when it comes down. So, that may not be a clinching factor, but just at a margin, it could have a psychological effect. So, that was the reason why we felt that probably the rate hike could have been deferred for December.

But now that it has done, I think, and went by the commentary of the RBI's governor, it does look like that since the stance has also been changed, and for the first time, we have something called a calibrated tightening, which has been very clearly stated as being that there will not be any rate cuts. But again, based on data, based on circumstances, it could be a status quo or a rate hike. We do believe that there are more rate hikes which would be coming in.

And since we're on this particular subject, I would say we could be expecting two more rate hikes, one in December and one in February.

Puja Mehra: In fact, he explained to the press conference that the term calibrated means that it is a milder form. But preceding the review, there was a lot of commentary from many of your colleagues who were saying that there shouldn't be such a change in stance. What did you think of that?

Madan Sabnavis: So actually, you know, the whole concept of a stance has been fairly nebulous, because at one point of time, we felt that when you have a stance being accommodative or not accommodative, it was more a case of saying that we will make sure that liquidity is provided. But then as a function of a central bank, you always ensure that liquidity is adequate and it's stable so that there's no question of availability of funds. The next question is that then what should a stance actually denote?

So I think over the last few years, especially after the Ukraine war, I think when it came up the concept of withdrawal of accommodation, it was basically a case of saying that, look, we are now preparing you for further rate hikes. Now, when you're saying calibrated, it looks slightly milder than saying withdrawal of accommodation. Withdrawal of accommodation may mean that, look, I'm pulling everything back, I'm going to hide things in a drastic manner.

Whereas when I say calibrated, it sounds more gentle a term to use. But that's one of interpretation. But the very fact that you're saying I'm not going to cut rates, it definitely means that it's going to be a rate hike, given the fact that the inflation trajectory, especially for the next three quarters, is going to be 5.8%, which is very close to the ceiling of 6%, which monetary policy is supposed to be targeting.

Puja Mehra: Also, I felt that the governor seemed to stress that it would largely be domestic conditions, inflation growth dynamics that would drive monetary policy even now, although he did not dismiss global factors completely. But the Fed’s rate hikes and their cycle, don't you see that as any influence at all on their decision making going forward?

Madan Sabnavis: So actually, if you look at the way in which the commentary is made, it's always a case of saying that monetary policy is targeting inflation, because that's what it's been mandated to do. So therefore, that 4% number or whichever number you're looking at the band of up or down is something that really matters. But this said, I think something which the RBI has always stood by is saying that we cannot ignore what is happening internationally.

Because when we're talking in terms of what the Federal Reserve does, it also has repercussions not just on what's happening in the US markets, but also in terms of how bond yields move. Because if the US bond yields move upwards, there's also a tendency for Indian bonds to move up. And that, again, has a bearing on how foreign investment flows behave.

That has a bearing on what happens to the currency. What happens to the currency has a problem on what happens to liquidity. So I think all of them get interlinked.

If I have to put it in a brief manner, I would say, OK, not the primary motivation for the RBI. But definitely, it's a secondary consideration and something which cannot be ignored because it has wider ramifications in terms of liquidity management at the end of the day, which is also part of the central bank's purview.

Puja Mehra: And they also seem to underplay the fallout that the rising cost of capital globally can have on cost of capital. They said we have sources of savings and investments domestically that we can tap into. But is that really something they can completely rely on?

Are we so decoupled from the international global capital markets?

Madan Sabnavis: No, I would tend to think they're not actually decoupled. That may not be the right way of looking at it because we do require global capital. And what we have seen is that a country like ours, we do run a current account deficit.

It may be coming down like what it's done in the last couple of years. But we do have a current account deficit, which means if we have a current account deficit, I do require foreign capital to shore it up so that my balance of payments are stable. And what we saw last year was that we had a deficit, which meant that there was an outflow of foreign exchange.

So therefore, I think foreign capital is very much important. But this said, are we actually dependent on these foreign funds for capital formation? At this particular point of time, probably not because I think domestic savings are taking care of it.

So it's more, I would say, a balance of payments concern what happens on the external sector, which is why we should be concerned about what happens to the flow of foreign funds. Because maybe we've not yet reached an optimal growth level, which necessitates higher capital formation. We don't have those kind of numbers of 35%, 36%.

But once I have capital formation rates of around 35% to 36%, at that point of time, I may just feel that with Indian savings not really going up to the extent to which they should, we would be relying on foreign capital. So the overall growth process today is in a kind of a comfortable equilibrium where I think domestic savings are taking care of it. But if we have to reach that potential growth of, say, 8% plus, then I think we would necessarily have to rely on foreign capital.

And this is where FDI makes a difference. And I think this is something which the RBI governor also spoke of, saying that gross FDI has been very high and encouraging. But the other part of the story is that if you look at the repatriations, the output foreign direct investment, the net flows which are actually coming in, have been fairly lacklustre in the last couple of years.

Puja Mehra: Right. And I also want to ask you about liquidity. He did say they will drain out all of the excess liquidity that they're seeing because of the FCNRB deposits by the end of this financial year, which is March next year.

And he also said he did not really prefer the CRR route, although it is on the table. How do you see it?

Madan Sabnavis: So in terms of liquidity, I think the overall goal is to make sure that the call rate, call market rates are aligned with the repo rate. I think that is the overarching objective of the RBI. Now, if you look at the overall, how do I look at this 5 to 6 lakh crores of surplus liquidity, which is there?

One thing is that we have the busy season coming through in the way in which credit has been growing. There's a very good possibility that it could get absorbed. Therefore, there would not be any problem when it comes to the surplus liquidity which you're talking about.

The other thing is that suppose it doesn't happen. And this is also a case of saying the domestic deposits continue to increase in normal course, which would really mean that we would have this surplus. So I think the RBI would like to rate and watch and see how these surpluses evolve.

And in this interim period, I think the right way to do it is to go in for the VRRR auctions, which is what they have been doing. So that's the way in which you handle these surpluses. But this may not be the optimal thing from the point of view of the banks, because you've raised these FCNR deposits at, say, 6.5%, 6.75%. And you're deploying it in the VRRR, which is coming at 5.24%. So maybe now it comes around 5.5%. That may not be the right way of deploying these funds. So definitely the banks would be concerned and would like to push forward with the credit to make sure that you're able to earn a positive return over what you have tomorrow. But the RBI, I think, will wait and watch. They will probably wait for the next three months or so.

And then they can take a call on whether there should be an all-more calendar where you announce to the market saying, I'm going to take out 1 lakh crores, which they did some time back, or whether you should go in for an IHCRR. But a CRR hike, to my mind, would not be right, because I think FCNR funds came in because you were given the guarantee that they would give you a CRR. So I would actually say the CRR is not on the table right now.

It would be more a case of using the open market operations in case the surplus is really ballooned to higher levels.

Puja Mehra: I also thought, when he was asked a question in the press conference about the projections that the RBI makes, he seemed to suggest that these are very dynamic numbers and they're not all that firm. What did you think of that? It has been a longstanding criticism of the RBI's projections that they do tend to change them and they're off the mark quite often.

Madan Sabnavis: No, actually, Puja, this is an interesting question, because I think it's not RBI, it's all economists. Because we also have been changing our projections every now and then. And I don't know if a group thing comes in at some point of time, and all of us seem to be moving in a similar direction.

But I think the way in which, because earlier I remember that we would just have these projections twice a year. You would have it halfway through at the beginning of the year. But they were more a case of aspirations and not really fine-tuning of these projections.

Because I think with more contemporary data coming out, I think this new concept of now-casting, I think it's called, that's what they keep doing, where everybody has something based on, I get some PMI numbers, I get some export numbers, I put it in my mortar and I get a new number. And if that number looks good with the contemporary times, I'm able to scale it up. If it's not, maybe after two months, I bring it down.

So I think with these sophisticated models coming in and more data being available, that is the so-called high-frequency indicators, I think there's always this temptation to do better than just making one forecast for the year. So that's the reason why these forecasts become more dynamic. And also the fact that the global environment has changed considerably.

When tariffs come, we cannot really sit back and say nothing's going to happen. But last year, what we saw was, irrespective of tariffs, the economy did very well. So we also have these kind of situations.

Q1 was a time when we had the Iran war. All of us spoke of doomsday, crude oil going to 140, inflation shooting up, so on and so forth. But we got 7.8% growth number. So I think there's a lot of this calibration of numbers also, these growth forecasts, new series which have come out, models being altered every now and then. This combined with too many of these high-frequency indicators coming in has made forecasting become more popular, which leads to more frequent changes in the overall forecast. So I think everybody assumes that visual forecasts made even by me as an economist, holds for the next two months.

Maybe that would again undergo a change because of these dynamic conditions.

Puja Mehra: I think forecasting is becoming challenging for all central banks around the world. You're seeing that. So anything that surprised you?

You did say that you had a contrarian view, but anything that surprised you in what has happened today?

Madan Sabnavis: If you ask me what has surprised me is, normally it's always said that six economists have seven or eight views. I mean, that's the whole joke.

Puja Mehra: On the right hand and on the left hand.

Madan Sabnavis: Yeah, on the left hand, right hand. So all of us could actually have two views on the same thing. But this time, I think all the six members have unanimously voted for a repo rate change.

However, for the stance, I think two have said that we should not be changing the stance. So I would have actually said you change the stance and not the repo rate. But yes, that came as a surprise that it was a unanimous decision.

In fact, even internally, in a lighter manner, I was hoping that at least one member would say that there should be a pause. I would have said I'm not too wrong, but yes, I've been totally proved wrong because of the contrarian view which was taken. Of course, there was a justification for it.

But I think the majority view did finally prevail.

Puja Mehra: And I don't think anything is not calibrated. So I was also a bit surprised by that.

Madan Sabnavis: Yeah, I think the calibrated part has become, I think, more frequently spoken of in this particular policy, not just in terms of calibrated tightening, but also in terms of handling liquidity. Everything's being done in a calibrated manner. So I think that's also another significant point in this particular policy.

Puja Mehra: Right. So thank you. Thank you so much.