Ineffective rate transmission is worry:
RBI shifted into rate cut cycle in 2015 with two-step reduction in policy rates, pushing Repo rate down from 8.0% to 7.5%. RBI also diluted tight money policy stance through 50 bps cut in SLR from 22.0 to 21.5%, releasing additional monies into the system. It sounds good, and in ideal market conditions, lending rates (reflected from Bank's Base rate) should have reflected a parallel shift. But it is not the case with Banks reducing deposit rates and not lending rates! So, it is inefficient policy transmission and worse, it is ineffective to the discomfort of the Finance Minister and worry for borrowers.
The lack of policy transmission is due to elevated T-Bill yield at the shorter end of the curve; 91-364D sovereign yields are at 8.0-8.25% against Bank's CD rates of 8.25-8.50%. When the liability profile of Banks are skewed at shorter end, the yield inversion across 1-10 years (at 8.25 to 7.75%) has no impact on transmission. Assuming that lower cost of CASA deposits are covered for statutory and priority sector cost subsidisation (at higher operating costs to manage CASA portfolio), there is no room for Banks to cut Base Rate below 10-10.5% covering for operating & credit costs to maintain NIM at 2.5-3.5% and RoA at 1.5-2.0%. All taken, borrowing cost for borrowers (excluding blue chip and AAA clients) continue to stay high.
Need to remove restrictions at Repo counter and prepare for shift of operating policy rate from Repo to Reverse Repo rate
RBI continue to have firm grip on system liquidity through restrictions on availability of refinance at overnight Repo and part from term Repo counter. This means that full amount of excess SLR held by Banks is not available on tap at Repo rate. If this has been allowed, the rate curve will be inverted even at shorter end across 7-365 days in anticipation of rate cut and risk of call money rate sharp fall from 7.5 to 6.5% on marginal surplus liquidity. When Banks hold excess SLR to the tune of 5-7% of NDTL (against requirement of 21.5% and HTM protection for 24%), Repo coverage at 0-2% of NDTL gives limited room for rate pass-through to borrowing rates. Therefore, it is obvious that rate transmission will be more efficient through shift of system liquidity from deficit to surplus, without the need to cut policy rates from here.
RBI has two options now; either allow the operating policy rate shift from 7.5 to 6.5% through liquidity injection or deliver 50-100 bps rate cut to drive Repo (and operative policy) rate down from 7.5% to 6.5-7.0%. Given that SLR cut is cosmetic when banking system is in huge excess SLR mode, can RBI do more than 1% CRR cut?
Most cues in favour of lower operative policy rate
When FY16 GDP growth target set at 8.0-8.5%, momentum in core manufacturing sector at 1-2% is dismal. The growth agenda around infrastructure, agriculture, Make-in-India manufacturing and social inclusion will have lag impact on FY16, with significant impact on FY17-FY19. So, there is immediate need to cut cost of capital and finance. The long term risk on interest rates from twin-deficits are no more relevant. The comfort on Rupee is the other way now, not minding the rate-cut driven Rupee weakness into 63-64. The risk from FED shift into rate-hike cycle by June-December 2015 is diluted, given the huge external appetite on India. Most off-shore investors (and lenders) have significantly increased their India risk appetite, and in wait-and-watch mode for viable India opportunities. All taken, there is space for downward shift in operative policy rate from 7.5% to 7.0%.
Inflation outlook is mixed in the short term, which is holding RBI now!
RBI has set linkage between CPI and operative policy rate, with a spread of 1.75-2.0% between CPI and Repo rate. At this stage CPI around 5.5% and Repo at 7.5% fit into this benchmark. The concern however is the risk of CPI pressure into 5.5-6.0% on high food inflation. The flip side is the ease in fuel inflation with delivery of price cut in alignment with stability in Crude Oil price and Rupee exchange rate. Can delay in rate cut help soft landing of food (and essential items) inflation?
Obviously, No! If the FM could give assurance to the Governor that food inflation target will be managed through adequate supply (and ensure sustainability through addressing supply side concerns from monsoon impact), then RBI should not have hesitation in delivering 25-50 bps cut despite with short time lag, post the delivery of pre-Holi 25 bps rate-cut.
Choice between rate pause (with 50-100 bps CRR cut) and dovish guidance or 25 bps rate cut with caution on the way forward
It is not difficult for RBI to defend either a rate cut or short pause stance on 7th April policy review. More than the rate move, stakeholders will be more eager to get relaxation on the Repo counter that would push the 3-12 months sovereign yield curve closer to Repo rate if not below, against guidance of lower rates ahead. It will also be good for RBI to complete the rate cut cycle before FED begins rate hike cycle, earliest by June 2015. All taken, I would not be surprised to get 25-50 bps rate cut on 7th April, taking time (for better clarity on inflation trend) for release of restrictions on the refinance of excess SLR. If RBI view this as being over reaction ahead of better clarity on FED rate-hike timing (expected to be any time between June-October 2015), then guidance of short pause (on rates) and 50-100 bps CRR cut with higher entitlement at overnight Repo rate would be adequate (and desirable) for now.
Impact on markets: retain bullish consolidation in the short term
Gilts (and corporate bond) yields will ease, doubt is on the extent. 10Y benchmark 8.40% 2024 would prepare for consolidation at 7.55-7.70% on rate cut or expectation of cut in May 2015.
Equity market will shed bearish risks for shift to bullish (on rate cut) or neutral (expectation of cut sooner than later) undertone. NIFTY has now set firm short term base at 8270-8470 with pent-up momentum beyond 8550-8630 into 8785-8850, seen as short term cap. Bank NIFTY base at 17700-18100 is seen firm to retain bullish momentum beyond 18500-18750 into 19350-19500, seen as short term cap. It will be prudent for strategic investors (who have stayed invested from August 2013 to May 2014) to unwind part (or in full) while NIFTY at/above 8785-8850 (Bank NIFTY at/above 19350-19500) for push-back into 8000-8300 and 16500-17500 ahead of FED rate hike actions, as knee-jerk move to set up next round of strategic play.
The main concern will be on Rupee for minor shift of focus from 61-63 to 62-64, which is seen good for the system to balance exporters interest and inflation control. Given that worry on fuel inflation is behind, allowing marginal adjustment in Rupee exchange rate will be good to support exports and to realise the Make-in-India ambition; marginal weakness in Rupee (adjusting for recent USD strength) will be good for pipe-line FDI flows and exporters, without significant adverse impact on importers.
All taken, there are no cues to suggest set up of bearish undertone post-policy but need to tighten the belt for volatility within the set short term ranges of 8270/8470-8785/8850 (in NIFTY), 17700/18100-19350/19500 (in Bank NIFTY) and 62.00/62.50-63.50/64.00 (in USD/INR).
Good luck
Moses Harding
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