India: groundhog day again – a cautious central bank, an ugly trade deficit :JPmorgan

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As had been increasingly expected since INR pressures started a month ago, the RBI today kept both policy rates and reserve requirements (cash reserve ratio) on hold. The rupee’s sharp depreciation in recent weeks was clearly weighing on the central bank’s mind because it indicated that the decision to stay on hold was driven by the “evolving growth-inflation dynamics…..as well as recent developments in the external sector”

RBI lobs the growth ball into the government’s court

On the growth front, the RBI admitted that growth and macroeconomic conditions remain weak, “hamstrung by infrastructure bottlenecks, supply constraints, lackluster domestic demand and subdued investment sentiment.” That said, the central bank pointed to some rays of hope referring to a pick-up in consumer on-durables (as we had highlighted in “The Indian soap opera: INR stabilizes, Fitch upgrades, IP languishes and CPI disappoints,” MorganMarkets, June 12, 2013), the May services PMI and a strong and timely monsoon thus far.

Yet, the RBI was clear what it considered to be the main drag on growth, stating that the “key to reinvigorating growth is accelerating investment by creating a conducive environment for private investment, improving project clearance and leveraging on the crowding-in role of public investment.”

Sees upside risks to inflation

The RBI acknowledged that WPI inflation pressures have moderated meaningfully but in line with projections. However, it saw “upside pressures on the way forward from the passthrough of rupee depreciation, recent increases in administered prices, and persisting imbalances, especially relating to food, pose risks of second round effects”

The central bank clearly has a point. Much is made of global commodity disinflation, but the rupee depreciation has swamped this. As the accompanying charts show, measured in local currency, the CRY global commodities index is the highest in seven month! And, oil prices, are 7% higher in local currency than a month ago – necessitating a two rupee petrol price hike over the weekend. The only open question is whether the pass-through from rupee depreciation to manufacturing inflation will be lower than previous episodes because pricing power is weak? But wishing for that is living on a hope and a prayer.

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Rupee, external sector stabilization key to next rate cut

In its guidance, the RBI stated the obvious that the policy stance will be determined by “how growth and inflation trajectories and the balance of payments situation evolve in the months ahead.” Yet, it did raise the bar for future easing by also indicating that “only a durable receding of inflation will open up the space for monetary policy to continue to address risks to growth” and further that they would need to be “vigilant about global uncertainty, the rapid shift in risk perceptions and its impact on capital flows”

As we have noted even before the review, (see, “India: WPI inflation moderates further but unlikely to induce a rate cut on Monday,” MorganMarkets, June 14) we believe the stabilization of the Rupee and some mean-reversion will be a critical prerequisite for rate cuts to come back on the table. In addition, the RBI will likely need to see some evidence that the trade deficit is narrowing, food inflation is abating, and the risk of passthrough from the FX to inflation – which could interfere with the “durable” receding of inflation –is limited.

A rate cut in July cannot completely be ruled out. The June trade deficit is expected to narrow substantially and that will help calm nerves. But the June inflation prints become crucial, because they will reveal early evidence of any INR passthrough into inflation also what’s happening to food inflation and therefore headline CPI inflation from the progress of the monsoon. The most important variable, of course, is the global environment and whether the Rupee settles down from here or is subject to more gyrations. If a critical mass of these variable move favourably and the INR has partially mean-reverted, the growth-inflation dynamics could yet force a July cut. But barring a confluence of all these factors, July could well be an action replay of June.

An ugly May trade deficit

The only thing more predictable than the RBI staying on hold was that the May trade deficit would remain bloated. And the data did not disappoint.

Recall, the April deficit had set the cat among the pigeons as it almost doubled to $17.8 billion from the month before, on surging gold imports, exports falling-off and non-oil, non-gold imports picking up pace.

It’s gold again

May was an action-replay of April. The deficit surged further to $20.1 billion on the same dynamics as the previous month. Predictably, the focus was largely on gold and silver which increased further from $7.5 bn in April to $8.3 bn in May. The sharp increase over the last two months is likely a response to the drop-off in global prices and it is hoped that this constitutes a front-loading of demand versus an increase in demand on account of lower prices.

To be sure, gold imports have fallen off sharply over the last few weeks, presumably as this front-loading has abated and some of the regulatory tightening measures have kicked in. So gold imports should fall dramatically in June (the World Gold Council estimates 50 tonnes of imports in June versus 162 tonnes in May). And this will result in a gapping-down of the trade deficit this month. Yet, June is also a seasonally lean month for gold. The test for whether April/May constituted front-loading versus incremental demand will truly come when gold is expected to pick-up again in August/September as the festival season approaches.

But also disconcerting non- gold dynamics

The exclusive focus on gold has concealed other disconcerting trade dynamics. Exports continue to fall-off sequentially, which is surprising given some pick-up in PMI export orders in recent months. Furthermore, like last month, non-oil, non-gold imports continues to tick-up (accounting for $1.8 billion of the 2.3 billion month-on-month deterioration in May), consistent with the observed pick-up in consumer non-durables. So the non-oil, non-gold deficit also likely worsened in May.

For now, however, even these troubling trade dynamics are not top-of-mind. Instead, Rupee watchers nervously await the FOMC statement and Bernanke’s press conference later this week.