Economy: RBI signals a clear focus on inflation-fighting, even at the cost of GDP growth :: Ambit

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The Event

• The RBI hikes policy rates by 50bps: The RBI as a part of its annual monetary policy review increased both the repo rate and the reverse-repo rate by 50bps each – ahead of our expectations of a 25bps hike. The repo and reverse repo rate now stand at 7.25%% and 6.25% respectively.  
• The RBI administers the global best practice of a ‘single policy rate’ system: As per the new scheme, the repo rate will be the single policy rate with the reverse-repo rate and a marginal standing facility rate (MSF rate i.e. the rate at which SCBs can borrow up to 1% of NDTL) forming the lower and upper corridor of the policy rate corridor respectively. The new policy corridor is now defined as the 6.25% reverse repo rate, the 7.25% repo rate (the key policy rate) and the 8.25% MSF rate. Whilst the width of the corridor is fixed at 200bps, the RBI retains the flexibility to alter this width.
• The RBI expects weaker GDP growth and firm inflation in FY12: In tune with its policy stance of checking inflation even at the cost of GDP growth, the RBI placed its GDP growth forecast for FY12 at ~8% YoY with a 90% confidence interval of 7.4% YoY to 8.5% YoY (assuming normal monsoons and crude oil prices averaging at US$110/barrel).  As regards inflation, the RBI expects inflation to persist ahead of the RBI’s comfort zone of 4-4.5% for the whole of FY12 with the baseline projection for WPI inflation for end-FY12 placed at 6% YoY with an upward bias.

Note: The long term average rate refers to the average monthly policy rate over Jan 2001 to Mar 2011. 
The key policy rates used for India, China, USA and EU are the repo rate, the rediscount rate, the fed funds rate and the main refinancing rate respectively. 
The long term average policy rate for India, China USA and EU is 6.9%, 2.9%, 2.3% and 2.6% respectively. 
The stock market indices used for India, China USA and EU are the Sensex, the Shanghai stock exchange, the S&P 500 and the Dow Jones Euro Stoxx respectively.

Our view

• Steeper monetary tightening bias expected: Whilst we highlighted our expectation of weaker GDP growth in FY12, our previous estimate of a 75bps increase in policy rate(s) over CY11 was based on our expectation of the RBI assuming a less aggressive stance versus inflation on account of GDP growth concerns given the clear weakness in investment demand.

Given that the RBI has now clearly indicated its  focus on inflation-fighting even at the cost of GDP growth in the near term and given that the lower limit of RBI’s forecast GDP growth is as low as 7.4% YoY, we expect the RBI’s monetary tightening bias to be stronger than previously expected. The RBI has indicated that ‘it will persevere with its anti-inflationary stance’ and we expect the RBI to increase rates by another 75bps over CY11. We expect the RBI to increase the policy rate again and continue with its monetary tightening agenda by effecting another 25bps increase on June 16, 2011.

• The RBI prepares for eventual savings rate deregulation whilst simultaneously expediting monetary policy transmission  : Following the floatation of the discussion paper on the deregulation of the savings bank deposit interest rate last week, the RBI increased the savings deposit rates by 50bps to 4.0% with immediate effect as savings rates today are administered at artificially low levels.

By increasing the deposit costs in the banking system, the RBI has indirectly expedited the pace of monetary policy transmission by compelling banks to pass on rate hikes. Our banks’ analyst ASV Krishnan expects a majority of the banks to effect a 25bps hike in their lending rates (PLRs / base rates) before the end of this month itself.

Investment Implications

• High and rising policy rates to impose headwinds for equity returns: The monetary policy rate in India now stands at 7.25% i.e. ahead of the long term average of 6.9%. History suggests that equity returns are lower across markets ( i.e. in India, China, US and UK - see exhibit 2 above for details)  when the monetary policy rate is ahead of its long term average. We expect the RBI to increase policy rates by another 75 bps over CY11 which means that the key monetary policy rate will persist at a level above its long term average over this year – something that history suggests will compress equity returns.
• Invest in ‘good and clean’ list: The RBI expects inflation in India in 1HFY12 to persist at ~9% over 1HFY12 and ease in 2HFY12 but continue to persist ahead of the RBI’s comfort zone. Given the strong domestic inflationary pressures affecting cost of raw materials and given that lower GDP growth will restrict pricing power of firms, margin pressure for India Inc is likely to persist.

Given that high inflation crunches stock market returns we recommend investment in 'good' (inflation-immune stocks) and 'clean' (stocks with high quality earnings) stocks. Find attached our portfolio of 'good' and 'clean' stocks, which has outperformed the BSE200 by 652bps as at May 2, 2011.

• Monetary tightening to affect cash-starved/ debt-heavy sectors disproportionately: An analysis of sector returns over the ongoing phase of monetary tightening suggests that sectors with greater ability to generate free cashflow (we measure this as cash flow from operations, as a percentage of EBITDA) deliver higher returns during a bout of sustained monetary tightening by the RBI (see exhibit 3 below).

Note: 1. Data has been calculated using consolidated financials for FY07, FY08, FY09 and FY10 for the BSE500 companies (excluding Financial Services companies)
2. The repo rate was increased by 200bps over Feb ’10 to March ‘11 and is expected to be increased by 75bps more over the rest of CY11

This dynamic clearly suggests that cash-starved sectors / debt-heavy sectors namely: (1) Construction, (2) Capital Goods, (3) Telecom, and (4) Real Estate will be impacted disproportionately as the cost of capital increases