RBI Surprises and Hikes Rates by 50bps – Odds Favor an Elongation of the Tightening Cycle Citi Research

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India Macro Flash
 RBI Surprises and Hikes Rates by 50bps – Odds Favor an
Elongation of the Tightening Cycle
 RBI Raises Rates by 50bps as Inflation Worries Dominate — The RBI surprised
market participants by raising the repo rate by 50bps to 8% vs expectations of a 25bps
increase. The persistence of inflation at +9% levels over the past 18 months coupled
with indications of continued pricing power appears to be key reasons for the move.
While we expected the repo rate to peak at 8%, today’s move, coupled with RBI’s
strong anti-inflationary stance, indicates odds of an elongation of the tightening cycle.
 Inflation:  Yes It’s High, and Will Remain Elevated — Headline WPI inflation and the
CPI have both been running at 9%+ levels. Admittedly, this is high  (3X the RBI’s
medium term target of 3% and nearly twice its objective of containing it at 4% to 4.5%).
While demand side factors have played a role (as reflected in higher wages, pricing
power), we maintain our view that prices will remain elevated due to: (1) Structural
drivers on food coupled with higher MSPs of agri crops (2) Upward revisions to past
data; and (3) Relatively higher commodity prices.  We thus expect the WPI to average
9%-9.5% in FY12 with revisions resulting in double-digit prints. The RBI has revised its
March 12 inflation estimate from 6% to 7%. We maintain our estimate of 8%.
 Rate Outlook – Pricing Power to be Key — The RBI has stated that a change in its
anti-inflationary stance “will be motivated by signs of a sustained downturn in inflation”.
With inflation likely to remain elevated, this seems unlikely in the near future. We could
thus see further ~50bps tightening by Dec-11. Key data points to watch are (1)
Corporate pricing power (2) 1QFY11 GDP data due on Aug 30 and (3) Govt finances.
 Implications: Risks of a Sharper than Expected Slowdown Emerge — Today’s
move is the 11
th
 rate action since the RBI began tightening, resulting in the repo rate
being raised by 325bps from 4.75% to 8%. Taking into account the transition from
surplus to deficit liquidity conditions, effective rate tightening is 475bps. While rates are
still lower than the peak of 9% seen in Jul-08, much further tightening could impact
growth – both on the consumption as well as investment side.
 Will the last quartile kill growth? — The current situation is becoming reminiscent of
FY09, where (1) the global crisis, (2) domestic elections leading to delayed investments
(3) policy tightening resulted in GDP slowing to 6% in 2HFY09 from 8% in 1H. We have
two of these now and while we're far away from a crisis on the global front, things are
clearly weaker than expected.  While the RBI has maintained its FY12 GDP estimate of
8%, we will be reviewing our 8.1% estimate keeping in mind (1) Investments – Our
numbers factor FCF decelerating to 5.4% from 8.4% in FY11. Projects have so far
been delayed due to policy uncertainty, but with banks already passing on today’s rate
hike; we could see further deferrals resulting in GDP at 7.2%. (2) Monsoons: If the
recent  improvement is not sustained, GDP could come off to 7.6%