The Reserve Bank of India surprised the markets for the second time in a row. The RBI cut the repo rate by 50bps in April when most analysts where expecting no change in the policy rate. Now, after the negative surprises in most growth indices, the markets were expecting the central bank to ease monetary conditions and the RBI stayed put.

Likely to turn pro growth

The RBI was far less accommodative in its policy statement than what was expected. The central bank’s less accommodative stance would clearly be sentiment-negative at the moment and would impart greater uncertainty regarding its future action.

That said, I do think that the RBI will likely turn pro growth in the coming months. Growth indicators have thrown much larger surprises compared with the inflation indices. Industrial activity is clearly weak and headwinds to growth still exist.

With distinctly slower growth and contained core inflation, I am convinced of the RBI cutting the repo rate in the coming month. In fact, the constrained fiscal health, especially in the wake of recent rating agency actions, and complicated political backdrop mean that the onus of supporting growth is more on monetary policy in the coming months. A policy rate cut on July 31 clearly remains on the cards, in my view.

Commodity prices

While headline inflation is higher than what the RBI would have liked, core inflation is certainly contained. Core inflation will broadly hover around 5 per cent in the coming months, which should allow the RBI to focus more on growth.

One factor which could have worried the RBI is global central bank liquidity injection and resultant higher commodity prices. In fact, the RBI observed that “….central banks in advanced economies will likely do another round of quantitative easing. This will have adverse impact on ….particularly oil importing countries such as India, through a possible rebound in commodity prices”. Better clarity on global central banks’ policy on liquidity infusion and the trajectory of commodity prices would offer the RBI the chance to decide on the course of further rate cuts.

In this context, it is worth highlighting that the Fed’s decision to extend “operation twist” and not do an unsterilised quantitative easing is beneficial for India. Price action in oil and other commodities after the Fed’s decision indicates that the markets are more concerned about global growth rather than liquidity injection led higher commodity prices. Note that before the RBI policy on July 31, we do have central bank meetings in the UK, ECB and BoJ which are expected to continue with easing measures. However, markets are largely expecting easing from these central banks and that is already reflected in current market prices. If any, a lesser than expected injection would see commodity prices lower from here.

Liquidity infusion to continue

Commercial banks will likely be forced to compete for the same pool of deposits by keeping deposit rates higher amid tighter liquidity conditions. This will limit the ability of banks to cut lending rates even if repo rates are lowered, in our view. Thus, there is need for the RBI to inject liquidity into the system and it does have the necessary tools to inject the required amount of money.

Even in this policy, while there was no liquidity infusion via headline making CRR cut, the central bank did change its tack on liquidity. It tried to engineer liquidity injection in a rather low-key manner, by increasing banks’ limit of export credit refinance from 15 per cent of outstanding export credit to 50 per cent. But importantly, the RBI promised action in a very unequivocal manner. It said, “Management of liquidity remains a priority. Even as the liquidity situation converges to the comfort zone, the Reserve Bank will continue to use OMOs as and when warranted to contain liquidity pressures”.

This is an indication that liquidity conditions are going to be easier rather than tighter. I wouldn't be surprised if the RBI continues with open market purchases in bonds fairly aggressively and wouldn't rule out a CRR cut either. The other positive externality of the bond purchases by the RBI is it helps lower bond yields and 10-year government bond yields can go as low as 7.50 per cent.

(This article was published on June 23, 2012)
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