RBI likely to maintain status quo on policy rates:: Edelweiss

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RBI POLICY PREVIEW
RBI likely to maintain status quo on policy rates


In the forthcoming quarterly review of monetary and credit policy on
November 02, 2010, the RBI is likely to maintain status quo on the policy
rates, leaving repo rate, reverse repo rates and CRR unchanged at 6%, 5%
and 6%, respectively. This expectation is based on our assessment of the
evolving domestic and global macroeconomic scenario and RBI’s last
meeting’s policy stance. Domestically, while the economic momentum
remains healthy, some softness is observed in industrial production, PMI
indices and exports growth. Growth in money supply has been quite soft,
credit growth is yet to pick up strongly, and inflation momentum is slowing.
These trends confirm our stated belief that there is no demand overheating in
the Indian economy. Hiking interest rates against such a macroeconomic
scenario could hurt business sentiments and, hence investments, especially
when monetary stance has already reached close to normal.
Internationally, expectations around another round of quantitative easing
(QE) measures by the Fed and associated surge in capital inflows to emerging
markets (EM) are presenting fresh challenges to EM central banks, including
RBI. First, the sudden surge in capital inflows to India raises concerns of
financial stability. On one hand, these flows are quickly reversible and, on the
other hand, they chase asset prices higher in a short span. Second, capital
inflows are putting upward pressure on INR, thereby hurting the export
sector. Third, expectations of Fed’s QE are driving the global
commodity/energy prices higher, which, in turn, influence the domestic
inflation trends. Here also, raising interest rates could prove counterproductive
as it will attract even more foreign capital into the country.
Against this, we expect RBI to pause in the forthcoming policy meeting.
However, it is quite likely that if capital inflows continue to remain very
strong, RBI will intervene in the forex market to check INR appreciation.
Further, the forex intervention could be unsterilised as domestic liquidity
conditions remain tight and money supply growth is running below target.
RBI’s quarterly review of monetary and credit policy is scheduled on November 02,
2010. In the previous policy review in September, RBI hiked repo rate by 25bps and
reverse repo by 50bps, intending to normalise policy rates and curb inflation/inflation
expectations. However, RBI acknowledged that with the move, the monetary situation
is ‘close to normal’. In the forthcoming policy meet, RBI will be taking into account
domestic inflation trends, global growth scenario, but would particularly be mindful of
the fresh developments with regards to monetary stance of the major central banks.



􀂄 No overheating in domestic economy
The economic momentum in India remains healthy, but we do not see any signs
of overheating. If anything, some softness in few macroeconomic indicators (after
a phase of impressive growth) is suggesting consolidation of growth around more
sustainable levels. The momentum in industrial production is easing and so is the
PMI manufacturing index (from ~58 in June/July to ~55 currently). Further,
exports growth is tapering off, money supply growth at ~15% is below RBI’s
target of 17% and non-food credit growth is yet to pick up strongly. Besides, the
appreciating INR would also have restrictive influence on aggregate demand.
Against this backdrop, monetary tightening could hurt business sentiments,
particularly when global growth environment is uncertain.


􀂄 Inflation on a softening trend
WPI inflation eased to 8.6% Y-o-Y in September from a high of ~11.0% Y-o-Y in April
2010. Manufacturing inflation also eased to ~4.6% Y-o-Y from ~6.4% Y-o-Y over the
same period. More importantly, non-food manufacturing inflation, which policymakers
track closely, has also eased from ~6.0% in April to ~4.9% in September. This softening
trend is in line with our view and we maintain that inflation is likely to cool off to 6.0-
6.5% by March 2011.
􀂄 Globally, race for weaker currency gathering pace
The Fed is facing prospects of renewed weakness in the US economy, with core inflation
hovering around multi-decade low levels. Accordingly, Fed is looking to introduce fresh
round of QE to boost the economic activity by lowering interest rates. However,
expectations of Fed’s another round of QE and associated surge in capital inflows to EMs
are presenting fresh challenges to EM central banks, including RBI.
For RBI, the first challenge is that the sudden surge in capital inflows raises the concern
of financial stability. On one hand, these flows are quickly reversible and, on the other,
they chase asset prices higher in a short span. Second, capital inflows are putting
upward pressure on the INR, thereby hurting the export sector. Third, expectations of
Fed’s QE are driving the global commodity/energy prices higher, which, in turn, influence
the domestic inflation trends. Here also, raising interest rates could prove counterproductive
as it will attract even more foreign capital into the country.
Similar challenges are being faced by other EM central banks as well, especially when
China is reluctant to allow meaningful flexibility in the RMB. Some EMs have responded
by intervening in the exchange rate market (South Korea, Taiwan) or by imposing some
sort of capital controls (Brazil, Thailand). These currency interventions could potentially
lead to trade frictions/protectionism building up as no coordination at global level seems
to be forthcoming so far.
􀂄 RBI to maintain status quo on policy rates
Against this macroeconomic backdrop of consolidation in domestic economic activity,
uncertain global growth environment and fresh challenges presented by surge in capital
inflows (anticipating Fed’s second round of QE). We believe RBI will prefer to wait and
watch until the monetary situation is close to normal. Accordingly, the November policy
review should see a status quo on the policy rates.
However, it is quite likely that if capital inflows continue to remain very strong, RBI could
eventually intervene in the forex market to check INR appreciation, just like many other
EM central banks are doing. Further, the forex intervention could be unsterilised as
domestic liquidity conditions remain tight (LAF is deficit mode) and money supply growth
runs below target.