Expectations from RBI monetary policy review: Mixed between cut or pause!

Comfort on the present but no confidence on the future

It is tough for RBI to defend "rate-pause" when CPI at sub 5% and twin-deficits in comfort zone. The system is also looking for significant reduction in cost of funds to improve earnings efficiency, and to bring down cost of capital to use (and expand) capacity. There is space for 50 bps rate cut going by the RBI formula of 1.75-2.0% spread between Repo rate and CPI print. What not clear is whether the formula to be applied on the current/past data or outlook on the future! Despite CPI trend into lower-half of 4-6% target zone, RBI is concerned on possible downside risks into 5.5-6.0% through rest of FY16. If such fear turns into reality, then RBI may need to push Repo rate to 7.5-8.0%. So, why cut rate now only to be moved up later? It may be better to pause to stay with the interest rate reduction cycle which began in January 2015. Makes sense!

Cost of capital (and liquidity) not seen as impediment to growth

System liquidity is in plenty and cost for good (and priority sector) credit is not high, while the opportunities to lend are few and investor confidence is euphoric but low. Credit growth in the last few years have been low, not withstanding the shift of credit from Bank to non-bank entities through CPs and Bonds (at cost 8-10%), leading to Banks holding huge excess SLR portfolio. The rate-sensitive sectors of Manufacturing, Automobiles, financial services etc have done well in FY15, clocking growth rate above 7.3% GDP growth. The laggards are mainly policy-sensitive sectors like agriculture, mining, infrastructure etc. When growth issues are from sectors which are not sensitive to interest rates and when RBI has little comfort on sustainability of CPI at 4/4.5-5%, the Governor will prefer not to act in haste and stay in pause till monsoon impact is felt on food prices. Brent Crude price impact is also not clear as the price has turned adverse from $45 to $70, against Rupee depreciation from 58 to 64. The downside risks of shift into $60-85 and 63-68 will be kept in mind.

Status-quo on liquidity

RBI may not see reasons to cut CRR when in aggressive $ buy mode. CRR cash would be needed for $ sterilisation to cover resultant Rupee infusion into the system. To compensate for this, there is case to reduce SLR from current 22% to 21%. Given that Banks are in excess SLR mode, cut of 0.5-1.0% will only result in arresting decline in medium/long term Gilt yields, and to maintain a flat yield curve across 1-10 years retaining neutral system liquidity.

50:50 probability between 25 bps rate cut and extended pause mode

RBI has already delivered 2 rounds of rate cut in Q1/2015, easing the Repo rate from 8.0% to 7.5% and administering overnight call money rate at 7.5-7.75%. RBI has already shifted into accommodative monetary policy stance and see no cues to turn into ultra-dovish stance as yet. There are opinions that RBI needs to follow other developed (and emerging) economies to stay easy on monetary policy through more rate cuts or shift of operating policy from Repo to Reverse Repo rate. But, those countries do not have issues around inflation and current account deficit. Currency depreciation resulting out of loose monetary policy will do more good than harm for those countries. But India economic dynamics are different, still not out of the woods on inflation and twin-deficits. So, there is case to stay in pause in Q2/2015 for assessment in Q3/2015 when there would be better clarity from FED on its rate hike cycle and resultant impact on Rupee and FPI flows. FPIs are not seen to be happy staying invested in India. The 2015 YTD performance on their India portfolio is negative both on asset valuation and exchange rate adjustment. US investors would have been better of staying with US and China, while Euro/UK zone investors would have got more through currency depreciation. RBI can't afford to have "run" on the Rupee, which will lead to liquidity squeeze and upward pressure on interest rates. All taken, it would be prudent to stay in pause while way ahead is not clear. When the choice is between devil and the deep sea, it is better to avoid both!

Outlook on macroeconomic fundamentals

RBI's FY16 GDP growth estimate at 7.8% may be retained. It is below Government's target of 8-8.5%. Given the FY15 base at 7.3%, it will be good if FY16 target of 7.8% is met. Given the upside potential from agriculture, natural resources and infrastructure, it is good to stay balanced on liquidity and rates till policy related impact is felt on the ground.

Given the downside risks from monsoon, Brent Crude and Rupee, RBI is expected to retain CPI target at 5.5-5.8%, not ruling out stability at 5.0-5.5% if risks do not turn into reality.

RBI is seen to have good comfort on twin-deficits. FY16 growth momentum into 7.8-8.0%, and plugging revenue leakages provide comfort on Fiscal Deficit trend down into lower end of 3.5-3.9% target. Current Account Deficit is also seen to stay in comfort at sub 2%, despite downside risks from higher Crude. The beneficial impact will be from FDI flows and Gold monetisation scheme.

All combined, interest rate impact on evolving macroeconomic dynamics is not significant, hence seen adequate. Beyond here, it may turn destructive causing more pain than gain!

What will Rajan deliver on 2nd June?

Option 1: Stay in pause through Q2/2015 for assessment in Q3/2015 post monsoon and FED stance. The guidance will be neutral and data dependent.

Option 2: Rate pause with 50 bps SLR cut, pushing Banks to shift appetite from risk-off Gilt investments to risk-on Credit portfolio. The guidance will be neutral and data dependent.

Option 3: Deliver 25 bps rate cut and 50 bps SLR cut, seen as balanced approach playing to the gallery (Government and borrowers) with zero impact on medium/long term yields (diluting impact on the investors). It will be good for marginal decline in the shorter end of the yield curve and marginal spike in the medium/long term curve at 7.5-7.75% across 1-10 years. The guidance will be neutral and data dependent.

Option 4: Deliver 25 bps rate cut, keeping SLR unchanged. The guidance will be hawkish with caution that rate can move either way ahead with data. It would mean that if CPI trends up into 5.5-6.0%, chance of Repo rate hike from 7.25 to 7.50-7.75% is not ruled out.

It is difficult to choose from the above 4 options. When it is tough, better to stay quiet till dust settles down! If I were the Governor, I will stay in pause in June 2015 till impact of Q1/2015 actions are felt! The cat will be out of the bag on 2nd June; in any event, impact on the markets will be neutral to bearish!

Moses Harding