MORE FOR LESS. Higher inflation bites as earnings dip
| Photo Credit:
Dhiraj Singh
The backdrop for the June 2026 monetary policy was the uncertain global economy, high energy prices, sharply depreciating currency and the threat of El Nino. The collective impact of these factors on the Indian economy is higher inflation and lower growth.The RBI, on expected lines, has maintained a status quo on the policy rate and retained the neutral stance. While energy prices have risen sharply, the pass-through to consumers for mass consumption items such as petrol and diesel started only from mid-May, before being revised upwards four times.To minimise the losses to oil marketing companies, the pump prices of petroleum products may be revised in the future as well. In the June monetary policy, the growth estimate for FY27 has been revised downward to 6.6 per cent from 6.9 per cent (April policy) and inflation forecast revised upward to 5.1 per cent from 4.6 per cent.The RBI governor, Sanjay Malhotra, has acknowledged that the risks of higher inflation have amplified; however, the banking regulator will wait for greater clarity before acting on rates. Future rate actions would be data dependent.Currently, one of the major headwinds for the Indian economy is the weakening of the rupee vis-à-vis the dollar. The dollar-rupee depreciated 3.1 per cent since the last policy (April 8) and 6 per cent since the beginning of the year. The weaker currency is acting as a catalyst for inflation.The key reasons for the weakening of the rupee include the continuous outflows from foreign portfolio investors (FPIs). India’s forex reserves at end-May declined to $682.32 billion — $14.8 billion lower than on April 3 ($4.48 billion lower than on January 2). The June monetary policy focused on improving capital flows into the economy.G-Sec limitIn a coordinated move the government has tweaked the tax policy for FPIs. On June 5 it exempted FPI investment in government securities (G-Sec) from income tax on any interest or capital gain with effect from April 1. To increase the participation of FPIs in the G-Sec market, the list of securities under the fully accessible route (FAR) now includes G-Sec of 15-, 30- and 40-year tenor and sovereign green bonds.The restrictions of short-term investment, concentration- and security-wise limits on FPIs have been removed and they fall under the overall investment limit of 6 per cent of the outstanding stock of G-Sec and 2 per cent of State government securities.According to NSDL data, as on June 5, FPI utilisation of the general limit was 9.2 per cent of the upper limit (12.2 per cent utilisation in G-Sec and 0.3 per cent in State securities). The unutilised general limit was ₹5.59 lakh crore ($58.57 billion using the dollar-rupee rate of 95.40). The changes in the tax policy for FPI investment in G-Sec and the larger pool of government securities available under FAR are likely to attract more investment in government securities to support the currency.In the monetary policy the RBI announced more measures to augment forex reserves: an increase in the investment limits for non-resident Indians (NRIs) and overseas citizens of India (OCIs) in traded equity instruments, and the extension of this facility to individual persons resident outside India (PROIs) at par with NRIs and OCIs; to incentivise external commercial borrowings (ECBs), concession forex swap is being provided to public sector undertakings (PSUs) until end-September; the full hedging for authorised dealer banks to raise 3-5 year FCNR(B) deposits will be borne by the RBI; and restoring the timeline for realisation of export proceeds to nine months.Tax reliefThe forex inflow into the government security market due to the tax relief for FPIs would largely depend on two key factors: the risk perception about India, which is unlikely to change significantly in the short run; and the comparative dollarised return from India vis-à-vis other markets.Withholding tax was one of the major reasons for India’s non-inclusion in global bond indices, so these measures are likely to provide some support for capital inflows. The steps taken to augment FCNR(B) deposits are likely to lead to relatively more capital flows into the economy.While the forecast suggests that inflation in 3QFY27 (5.9 per cent) may be closer to the upper tolerance of RBI (6 per cent), it may decline to 5.4 per cent in 4QFY27. With the annual inflation in FY27 being forecasted at 5.1 per cent, the real rate at present is 15 bp.The RBI has in the past articulated that to incentivise saving, the real rate should be positive; this suggests an increase in policy rate in the future. The RBI has also reiterated its commitment to maintaining adequate liquidity in the banking system to meet the productive requirements of the economy and facilitate monetary policy transmission.It is unlikely that the RBI will provide liquidity in the system and, at the same time, raise policy rate. This is precisely the reason for the future monetary policy decisions being data dependent.In our opinion, the assessment of the second-round impact of energy prices and the likely impact of El Nino on inflation could decide the future course of the RBI’s action. The system liquidity maintained by the RBI would be a lead indicator of its next policy action. Ind-Ra’s base case is a hold on policy rates even in the next monetary policy (August). This is driven primarily by the expected decline in inflation in 4QFY27 from 3QFY27.However, if the monsoon rainfall deviation from normal is more than 10 per cent and the war continues for longer and oil prices remain high, one may expect the RBI to take policy action even before the scheduled monetary policy committee meeting.
