RBI may opt for status quo on policy rate :: Mint

Please Share::

�� India Equity Research Reports, IPO and Stock News Visit http://indiaer.blogspot.com/ for complete details ��

��

-->

Driven by higher food prices, retail inflation in India accelerated to a nine-month high of 5.4% in June, from 5.01% in May, and above the consensus estimate of 5.1%. Yet, quite a few analysts expect the Reserve Bank of India (RBI) to cut interest rates on 2 August, when it reviews its monetary policy. Since January, the central bank has cut its policy rate thrice, by 25 basis points each time, and brought it down to 7.25%. A basis point is one-hundredth of a percentage point. The last rate cut was announced on 2 June after two back-to-back inter-meeting rate cuts in January and March.

There are many reasons behind such an expectation.

First, the monsoon—the biggest worry of RBI—is almost on track. The deficit in monsoon rainfall relative to the long-period average is lower than the 12% deficiency forecast by the India Meteorological Department (IMD). Even though the rainfall is not exactly evenly distributed, if the trend continues, this will have a positive impact on food prices and, in turn, inflation.

Second, global commodity prices, particularly that of crude oil, have been on a decline. Since the last policy review in June, the average price of Brent crude has come down by about 15%, from $65 a barrel to $54. This, too, will ease pressure on inflation.

Third, India’s factory output growth slowed to 2.7% in May from 3.4% (revised down from 4.1%) a month ago, pulled down by softer growth in manufacturing activities, exposing the fragile nature of the recovery. A lower rate will help prop up growth in Asia’s third largest economy—at least, that’s the popular belief.

Fourth, indeed the quickening of retail inflation in June was a nasty surprise, but going ahead, the base effects will come in play, and at least till August, retail inflation will remain low, below 5%, creating space for RBI to cut its policy rate. Incidentally, wholesale price inflation has been in negative territory for seven months in a row. In June, it was at minus 2.4%.

Finally, the uncertainties surrounding the timing of the proposed rate hike by the US Federal Reserve (Fed) still loom large and, hence, RBI should pare its policy rate now as the Indian central bank may find it difficult to do so when the Fed bites the bullet. Many believe this could happen as early as September.

The arguments are all fine, but my take is that RBI will opt for the status quo and wait at least till the next policy review to take a call on its policy rate. More than its action, the market will keenly watch for governor Raghuram Rajan’s guidance.

In the last monetary policy review, where RBI cut the policy rate by a quarter percentage point to 7.25%, the guidance was neutral—future actions would depend on inflation data, but the market reacted adversely, probably because it was not communicated well. RBI revised downward its estimate of growth of India’s gross domestic product to 7.6% from 7.8% for fiscal year 2015-16 even as its biggest concern was food inflation against the backdrop of the weather department’s estimate that monsoon rainfall will be 12% below the long-period average. The combination of uncertainties over the monsoon, rising crude prices and a volatile external environment had prompted RBI to underline the upside risks to its 6% inflation estimate by January.

The June policy document also made a pitch for a strong food policy to control inflation and inflationary expectations. “Monetary easing can only create the enabling conditions for a fuller government policy thrust that hinges around a step-up in public investment,” it said, making it clear that only if the government is able to address the supply constraints, inflation can be curbed over the medium term and create room for RBI to act on the rate front.

Indeed, retail inflation will ease in July and August because of a base effect, but food inflation remains a concern. Food prices rose in June led by a significant pick-up in prices of pulses, vegetables and eggs. Also, led by higher food prices, retail inflation in rural India rose much sharper than in urban pockets, widening the gap between rural and urban inflation. Besides, core retail inflation, too, rose to an eight-month high, led by a hike in service tax and a rise in petrol and diesel prices, and the trend may continue. Clearly, the war against inflation is not over as yet.

Similarly, factory output growth dropped in May, but the point to note is that it has now been positive for five months in a row, and the average growth since January at 3.5% is much higher than what we had seen in the second half of last year.

These factors may prompt RBI to wait and watch the full course of the monsoon, the government policies to address supply-side issues for containing food inflation, and keep a hawk eye on global commodity prices and the stance of the Fed before announcing the next rate cut. Its guidance may signal a stance that the rate cut cycle is not just over as yet.

Meanwhile, I will not be surprised if this policy review expands foreign institutional investors’ (FIIs) exposure to Indian debt either by raising the ceiling or fixing the investment limit in rupee terms instead of dollar. Three successive rate cuts have not had much impact on bond yields because of lack of demand with FIIs nearing their buying capacity limit. FIIs can buy up to $25 billion of government bonds; long-term funds can buy another $5 billion, taking the total exposure to $30 billion. The utilization limit by foreign investors in both these categories is over 99%.

Tamal Bandyopadhyay, consulting editor of Mint, is adviser to Bandhan Financial Services Pvt. Ltd, India’s newest bank in the making. He is also the author of Sahara: The Untold Story and A Bank for the Buck. Email your comments to bankerstrust@livemint.com.