The recent change of guard at the finance ministry, putting the person at helm of affairs who initiated India’s march towards a market-based economy, has been viewed as constructive by various stakeholders in the economy. While this development is certainly a positive, confidence could have been further bolstered had the RBI sent a strong monetary easing signal. Instead, the central bank, in its recent monetary policy, chose to keep rates on hold. Based on our recent interactions with investors, the street is divided on the possibility of rate cut. In fact, Mint Street’s action has led few to believe that there will be no aggressive rate cuts in the current fiscal as RBI continues to target headline inflation. However, our view remains that the central bank should resort to aggressive easing in the current year.
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Our argument is based on: (1) sharp decline in core/demand inflation; (2) supporting growth becoming a priority as overly tight monetary conditions are become extremely counterproductive; and (3) synchronised global slowdown requiring more flexible and proactive approach by central bank.
There are a few arguments against rate cuts. To begin with, there is a school of thought which suggests that an elevated credit deposit (CD) rate could further worsen if rates are cut. However, we are of the view that policy rates are not the reason behind sharp spike in the CD ratio in recent months and, therefore, cannot be the solution. Another argument often offered to keep policy rates elevated is the need to support the INR. We believe this too is not an appropriate policy prescription. To the contrary, elevated interest rates would hurt growth, fiscal consolidation and increase macroeconomic vulnerability of the country, thereby hurting capital flows rather than encouraging them. Accordingly, in our view, reducing interest rates will be a more fruitful strategy to support INR, than keeping them elevated.
In a nutshell, contrary to general expectations, we expect Mint Street to undertake aggressive monetary easing this year (~75-100bps in rest of FY13) as the domestic economy is operating far below potential and lag impact of high interest rates will continue to linger. This will keep core inflation under check. Besides, the global macro and financial market environment has worsened materially, adding to downside risks related to the domestic economy while global commodity prices have softened even in INR terms. Continued high interest rates at this stage will do more harm than good.
Regards,
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